Himani Phadke, senior sustainable investing strategist; Kandarp Acharya, senior portfolio manager; and Sophie Careford, senior solutions analyst, discuss how Allspring is tackling the challenge of delivering dividend income while aiming to reduce climate risk and the risks of the Russia-Ukraine war.
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Himani Phadke: I’m Himani Phadke, senior sustainable investment strategist on Allspring’s Sustainable Investing team, and you’re listening to On the Trading Desk®. Today, we’re discussing the topic of generating income from equities while also focusing on addressing climate risk.
Joining us are Sophie Careford, senior solutions analyst on the Systematic Edge team, and Kandarp Acharya, senior portfolio manager on the Systematic Edge team. They’ll be providing their insights on this topic. Thanks for being here, Sophie and Kandarp.
Sophie Careford: Thanks, Himani.
Kandarp Acharya: Yeah, great to be here.
Himani: So, Sophie, what do you see investors looking for these days when it comes to their returns or their objectives?
Sophie: Yeah, that’s a great question. So, one of the key asks we consistently see from our investors is the need for income. We really see it as an evergreen request. Whether that’s to benefit from income and growth while accumulating savings or to boost retirement income, we really think that the need for income-generating investments is here to stay.
However, over the last few years, one of the key questions has been where do we get this income from? We know that fixed-income yields remain at historic lows. So what we’re seeing is investors look beyond the relative safety to riskier asset classes, such as equities. With equities, they’re going to get the income that they need, but they also get that added benefit of higher capital growth.
But, Himani, it doesn’t stop there. In addition, we are increasingly seeing investors pointing their investments to contribute to a more sustainable planet. I mean, I know in my case, that’s what I want to see for my savings, as well. And when we look at the broader AUM (assets under management) and flow numbers, it really tells a story.
At the end of last year, according to a Morningstar report, there were $2.7 trillion assets under management in global sustainable funds. And on the flow side, there were $142 billion in flows, and that was just the fourth quarter alone. I think it’s clear to see that the demand for sustainability in investments is most definitely there.
However, delivering both income and improved sustainability—for example, the reduced risk of climate change—it doesn’t always go hand in hand. For us at Allspring, meeting our investors’ objectives really is our primary goal. So for us, exploring the dynamics between delivering both income and reducing the risk of climate change has been a real key area of focus for us.
Himani: Kandarp, why is it difficult to deliver income and reduce climate risk?
Kandarp: Well, as Sophie said, the search for income has led investors to move from fixed-income assets to riskier equities. Fixed-income assets, or bonds, have long played a dominant role in an income-generating portfolio for the last four decades, or as long as anyone seeking income recalls. Investors not only received a fixed coupon payment, but over this period, the interest rate trended downwards, providing additional price returns.
However, in the current rate environment, bond yields do not provide investors with sufficient income and will lose value as the rates rise. That leaves dividend income from equities as another potential source of income while also providing growth.
For example, the MSCI All Country World Index, or ACWI, as a benchmark for global equities, has a trailing 12-month dividend yield of approximately 2%. So if one were to include only the companies that have a dividend yield higher than 3%, or 1% better than the index dividend yield, we would find a portfolio of about 630 companies out of 2,956 stocks in that index that meet this higher dividend yield criteria.
Now compared to the ACWI, this portfolio would have lower exposure to the U.S. market where dividend yield in general is lower. But perhaps more importantly, the high dividend yield portfolio has more weight in the industries that are known to have a high carbon footprint and intensity, like utilities, mining, and construction. And not only that, it would have a lower weight in industries with a low carbon footprint and intensity, like software, internet, communication equipment, etc. The resulting carbon intensity of the higher-yielding portfolio is actually significantly worse at 417 versus 218 for the index.
So what we find is that companies that provide a high income in the form of dividends are often in sectors that tend to be some of the worst carbon-emitting companies. A naïve approach to find high-income equities may be correlated with higher carbon emissions, and this illustrates why it is difficult to deliver income and reduce climate risk.
Himani: Indeed. So, historically, companies who’ve paid higher dividends may not have been the best role models in terms of climate awareness. But with some focus, it’s possible to find ones that are and build a portfolio on that basis.
Now of course, the ideal situation would be a much wider array of companies across all sectors of the economy who are able to pay income to investors while managing their businesses with awareness of sustainability objectives.
Now in terms of actions investors can take around sustainability, what we’ve seen is that one way to encourage this direction of travel is through active ownership, to engage with the companies who need to move up the curve with investors being explicit about their expectations for this type of management.
The other aspect is more fundamental in nature. Is it reasonable to think that companies who do manage their climate transition and contribute to both thoughtful ESG (environmental, social, and governance) risk management and sustainability progress will be able to pay the types of dividends that investors are seeking?
Increasingly, it’s looking like this type of corporate behavior can help with long-term business strategy resiliency and for companies to be positioned to be on the right side of the sustainability megatrends that are underway.
In the short term, too, disruptive events, such as Russia’s war with Ukraine, show that there are huge geopolitical risks of depending on a country like Russia for Europe’s critical oil and gas supplies. And this might perhaps prompt a speeding up of the energy transition to renewables. Does this resonate, Kandarp? And how do you solve the apparent dilemma of delivering income and reducing climate risk from a security selection perspective?
Kandarp: It certainly does, Himani. And despite the apparent challenges, when doing some more research, we found that reduced climate risk and dividend income generation can actually coexist in a portfolio.
Now in the simplified naïve example that I referenced earlier, the portfolio we constructed only focused on higher dividend yield. In reality, our strategy identifies fundamentally sound companies with strong free cash flow to support the desired dividend income. And we use earning quality, as well, to find such companies.
Now here’s where it gets really interesting. We find a high correlation between our quality indicators and ESG scores, meaning that the income and an improved ESG profile can be achieved simultaneously. We view poor ESG scores as a sign of poor management and are wary of holding such companies for fear of value traps. By not investing in poor ESG-scored companies and targeting higher ESG scores in the portfolio appears to be well aligned with our goal of seeking high-quality companies that can afford to pay their dividends.
From a climate perspective, we seek to deliver a portfolio that targets a carbon intensity and a carbon footprint that is at least 30% below the benchmark. This lines up with the starting point for the EU (European Union) climate transition benchmark and is designed to tilt the portfolio to benefit from the transition to a decarbonized economy.
Some of the more natural income-generating sectors such as utilities, mining, and construction can prove difficult to balance from an income and carbon emissions perspective. And the key here is to appreciate the overall portfolio context that is looking to meet the climate-risk objective at the overall portfolio level versus on a company-by-company basis.
While income is a primary objective, total return is also important. We have the ability to invest up to 10% of our income-focused portfolio in a low- or zero-dividend-paying companies. This helps us take advantage of attractively ranked companies and, in turn, can provide an opportunity to improve the overall carbon emissions, if such companies are in low-emitting industries.
While there are trade-offs in delivering income, total return, and reduced climate risk, our view is that by following our process and improving climate risk at the overall portfolio level, we can meet our investor objectives.
Himani: Thanks, Kandarp. And do you have any thoughts on the potential impact of Russia’s war with Ukraine on efforts to deliver income while addressing climate risk?
Kandarp: On the topic of Russia’s war with Ukraine, short term, this has had an adverse impact on equities, especially European banks and growth-oriented equities.
The portfolio has been reducing the European overweight since the beginning of the year, and it always has had a value bias, both of which are helping outperform its benchmark since the beginning of the year.
Over a longer period, as the world transitions to renewables for its energy needs, we are actively monitoring companies that meet our selection criteria while improving their carbon footprint and intensity.
Himani: Thanks, Kandarp. And how does this approach potentially benefit investors?
Kandarp: Well, bringing this all together, our approach centers on three key pillars.
First, starting with a well-diversified dividend-focused equity portfolio using our climate-aware investment process to provide a strong income foundation as the first source of income.
Second, enhancing this income by collecting premium through an actively managed option strategy as a second source of income.
And then the third and final way is leveraging our decades of experience in asset allocation to dynamically balance and manage these two sources of income across business cycles.
As a result, this active and diversified approach allows us to solve for some of the key challenges in equity income investing.
Himani: Thank you, Kandarp and Sophie, for being with us today and sharing your insights.
Kandarp: Thank you, Himani. It was great to be here.
Sophie: Thanks, Himani. It was a pleasure to be here.
Himani: That wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com.
To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or whatever podcast subscription service you use. I’m Himani Phadke, and thanks for listening.
Disclosure: All investing involves risk, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics.
The Morgan Stanley Capital International (MSCI) All Country World Index (Net) (ACWI) is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. You cannot invest directly in an index.
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
Investment strategies that are not ESG-focused strategies may consider ESG-related factors when evaluating a security for purchase but are not prohibited from purchasing or continuing to hold securities that do not meet specified ESG criteria.