- High-dividend-yield sectors within developed markets have had an elevated carbon footprint on average, but a high dispersion in carbon intensity exists across sectors in higher-yielding stocks.
- In most sectors, and notably in high-yielding sectors such as financials and utilities, the relationship between ESG ratings and divided yield was positive.
- Our research suggests that investors could have theoretically improved the ESG and climate profile of their income allocations without sacrificing yield or causing high tracking error.
Global equity-income strategies were negatively impacted by the pandemic-induced pullback in the form of dividend cuts and cancellations. Since then, global inflation has risen to historic levels and equity markets have featured significant volatility and drawdowns following a spirited recovery. In short, recent macroeconomic turbulence has led asset allocators to rethink their tactical allocations. Our previous research revealed that, historically, high-dividend-yield portfolios have performed well in times of rising inflation and weak economic growth. In this blog post, we explore the potential construction of an equity-income portfolio with a lower carbon footprint and a heightened ESG profile, without materially-reducing dividend yield or increasing tracking error versus the standard market-cap index.
Yield, ESG and carbon through a sector lens
Investors increasingly incorporate ESG and climate considerations in asset selection. But for investors seeking stock-dividend yield, the major benchmarks they measure their performance against, have generally had a positive bias toward carbon-intensive sectors (such as utilities and energy) and a negative bias toward low-emission sectors (such as information technology).
We evaluated the relationship between average dividend yield, MSCI ESG Score and weighted average carbon intensity (WACI)1 across Global Industry Classification Standard (GICS®) sectors of the MSCI World Index universe (as shown below).2 There was a clear divergence between high- and low-dividend-paying sectors, with utilities yielding 3.91% on average and information technology yielding 1.08%. The historically top-yielding sectors did not have a strong bias in ESG ratings3 with communication services and utilities exhibiting large deviations from the MSCI World Index score. However, two of the sectors with the highest dividend yield, energy and utilities, had a greater relative carbon footprint than the broad MSCI World Index.
ESG score and carbon intensity of MSCI World Sector Indexes
ESG score and weighted average carbon intensity as of April 2022. Dividend yield is a monthly average from December 2010 to April 2021.
ESG and carbon in a high-dividend universe
We evaluated the distribution of MSCI ESG Ratings and WACI in equities with greater than a 3% grossed-up yield, which is higher than the average long-term MSCI World Index yield of 2.4%. Our research suggests that the relationship between yield and ESG ratings was generally positive. For high-yield stocks in most sectors, the proportion of ESG Leaders (companies with AAA and AA ratings) was much higher than ESG Laggards (B and CCC ratings), as shown on the left below. As of April 2022, there were a total of 236 stocks that had both a yield greater than 3% and a high ESG rating. The majority belonged to the five sectors with the highest average yield, led by financials and utilities, but were also present in traditionally low-dividend sectors such as consumer discretionary and industrials.
Conversely, the relationship between yield and WACI was not as constructive (as shown on the right below). Financials contained the highest proportion of high-yield and low-carbon companies, followed by consumer discretionary and communication services. Utilities and energy companies generally exhibited higher carbon intensity, with a high dispersion in carbon intensity across high-yield stocks. From a portfolio-construction view, a high dispersion in carbon intensity may present an opportunity to exclude outliers to minimize carbon footprint.
How ESG ratings and carbon intensity were distributed in high-yield stocks
As of April 2022. Dividend-paying stocks: 1,265 stocks, with 81.9% parent-index coverage. Stocks with more than 3% yield: 478 stocks, with 25.0% parent index coverage. WACI reported in tons of CO2/USD 1 million in sales based on Scope 1 and 2 emissions.
Integrating carbon intensity and ESG with income
The MSCI World High Dividend Yield Index, which targets persistently high dividend income, exhibited a higher carbon intensity than the MSCI World Index, with a marginal improvement in ESG score. To explore ways to potentially enhance carbon intensity and ESG score, we constructed two hypothetical portfolios: one based on a simple overlay and another using an optimization approach. Each portfolio targeted at least a 50% reduction in carbon footprint, 20% improvement in ESG score and dividend yield 30% higher than the market.
The overlay approach (Portfolio 1) screened for stocks with low ESG scores and high carbon intensity (after applying a high-dividend-yield methodology) and achieved the carbon-footprint and ESG-score objectives without sacrificing dividend yield, compared to the MSCI World High Dividend Yield Index. The hypothetical portfolio also exhibited similar levels of tracking error to the aforementioned index (as shown below), demonstrating that the ESG and climate integration did not require an additional risk budget.
The optimized approach (Portfolio 2), which targeted dividend yield, WACI and ESG scores, while considering tracking error, also met its targets while maintaining the same level of dividend yield as the MSCI World High Dividend Yield Index. In addition, Portfolio 2 was able to exploit correlations to achieve the most efficient trade-off across various target metrics.
Dividend-yield and tracking-error trade-off
May 2013 to April 2022.
Both portfolios remained well diversified, with 204 and 191 stocks on average, respectively, and provided a dividend yield that exceeded the MSCI World Index and approximated the MSCI World High Dividend Yield Index (as shown below). However, we believe the optimized approach (Portfolio 2) fared better overall due to its lower tracking error, higher income generation and lower performance deviation from the market.
A comparison of key valuation metrics
|MSCI World||MSCI World
|Total return (%)||10.0||7.9||8.3||10.3|
|Total risk (%)||13.8||12.2||12.2||13.3|
|Dividend Yield (%)||2.3||3.9||3.8||3.9|
|Tracking error (%)||-||5.0||4.9||3.1|
|WACI (t CO2e/$M sales)||151||208||74||75|
May 2013 to April 2022. Annualized gross USD index returns. ESG and climate metrics as of April 2022.
The potential to have it your way
Under our hypothetical examples, an improvement in the ESG and climate profiles of income allocations may not potentially incur higher tracking error or sacrifice yield. Although high-dividend-paying sectors exhibit a bias toward carbon-intensive companies, ESG and climate leaders and laggards exist within dividend-paying segments across sectors. With a growing focus on climate impact through investment, income-seeking investors may explore these and other alternative portfolio-construction approaches.
The author would like to thank Jean-Maurice Ladure and Abhishek Pankaj for their contributions to the blog.
1 WACI is calculated as tons of CO2 equivalent/USD 1 million of sales based on Scope 1 and 2 emissions. Scope 3 emissions, which would have impacted the analysis, are not included due to a limited data history.
2 GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.
3 MSCI ESG scores are industry-adjusted. High- and low-ESG-scored companies are distributed across sectors.