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Socially Responsible Dividends In An ETF

Cinthia Murphy

Columbia Threadneedle has 14 ETFs on the market today commanding more than $1 billion in total assets. Among them are three ETFs that launched last year, and merge environmental, social and governance (ESG) investing with a dividend focus. It’s equity income meets socially responsible investing, if you will. The funds are:

Ed Kerschner, Columbia’s chief portfolio strategist, walks us through the process behind blending these two investing themes in search of one single outcome: finding sustainable income.

ETF.com: Your ETFs merge two popular trends in ETF investing: dividends and ESG. Is that how investors should interpret these portfolios?

Ed Kerschner: That's a good way to look at it. We approach it as an answer to the question, “What's the need out there among investors?” We’ve been talking about something I'm calling the “new rate regime.” For the first time in four decades, interest rates stopped going down, by definition, once you hit zero. I'm not saying they have to go up a lot, but essentially you've had a tail wind for four decades, and now you don't.

So we began our process with a search for dividend income. Stocks that grow their dividends historically outperform the market, and stocks that don't grow their dividends underperform the market.

And for stocks that cut their dividends, you need to anticipate that the damage is done the year before they cut it, not after. If you wait until they cut, it's too late. So, we've developed screens that look at different cash flow and dividend coverage numbers to hopefully avoid the dividend cutters.

We’ve found that, on average, if a stock cuts its dividend, it is down more than 20% in the year before it cuts its dividend, and it underperforms the S&P 500 by about 32.5 percentage points the year before the dividend is cut.

ETF.com: And the ESG component to this process?

Kerschner: ESG is probably very misunderstood. In fact, I just got a new paper from Ernst & Young, and one of the data points is that 74% of respondents think the reason you do ESG activities is to build your corporate reputation with customers.

There's still this nagging perception that an ESG investor wants to do good. The reality is that the majority of investors still believe they have to give something up to be an ESG investor. And that’s not true at all.

You get into this issue called “materiality.” If you screen companies for factors that are in environmental, social and governance that are material specifically to their industry, you find that these companies outperform.

 

Think of it this way: Wastewater management is probably not a big deal for a bank, but it’s important for a steel company. Customer privacy is really important for a bank, but probably not for a cement manufacturer. ESG is a marker of good management.

What you want to avoid is an E, S or G event, if you can. It could jeopardize stock price, it could jeopardize dividend, etc.

To that end, one of the screens we use looks to avoid companies that have below-average ESG rankings, which is interesting, because 43% of the S&P 500 market value has below-average ESG ratings: in other words, almost a 50/50 chance that you're taking ESG risk.

We try to avoid ESG risk, and avoid dividend vulnerability, looking for dividend growth. That’s what these ETFs are about.

ETF.com: The top holding in your U.S. fund, ESGS, are companies like HP, Gap, Nordstrom, Boeing. I have to admit those aren’t companies I think of when I think of ESG investing.

Kerschner: We're not saying “let's buy the highest ESG scores.” We're saying “let's begin our search for dividend with companies that don't score poorly on ESG factors.” All these companies have good ESG ratings, and they have a dividend, a dividend growth and by our analysis, the ability to sustain and grow that dividend looking at other financial metrics.

ETF.com: So there’s ESG investing for investors looking for income and return, not necessarily to be green.

Kerschner: I think of it as ESG investing for an ESG investor. You don't want to invest necessarily in a company that has splendid ESG factors but terrible financial factors. That doesn’t make sense. You don't want to motivate mediocrity.

ETF.com: For implementation, these strategies fit in an investor’s income bucket, right? What’s the outlook for them?

Kerschner: Right. The biggest challenge going forward is finding income sources. From 1981 through 2016, 10-year bonds had an average return of 8.4%. Because you got your coupon plus capital gain, because interest rates went down, so you had double-digit returns in 13 of those years. And you had a 20% return four of those years.

People used to making a lot of money in the bond market averaged a return of almost 8.5%. On top of that, you've had this great bull market in stocks, which isn't necessarily over, but I don't know if you're going to get the kind of returns we've had going forward.

Historically, over 40% of your return from the S&P is your dividend. In recent years, it’s been in the 10-20% range, but I think you're going to go back to a period where close to half your return—or certainly more than a third of your return—will come from dividends.

As investors look for income and return, they're going to be looking to companies that have metrics that make that dividend sustainable. And ESG is a factor that makes that dividend sustainable.

 

ETF.com: If that’s the case, why don't we have more ESG dividend ETFs in the market? Is this a connection we're just now realizing?

Kerschner: Yes. I think it's only in the last year or two that you started to see the literature.

The other thing is, you didn't have the data availability. The Sustainability Accounting Standards Board has really grown rapidly, whereas 10, 15 years ago, you didn't have the degree of data disclosure that enabled us to do the kind of metrics and measuring of ESG factors that we have today. There’s a growing recognition that ESG's important, and there's a growing availability of data.

At Columbia, we've been involved with ESG investing since 1998. We have $11.3 billion in responsible investing mandates. We have a long history with it.

ETF.com: As far as socially responsible investing trends go, we recently had the launch of the first “green bond” ETF. Is that a segment that offers a lot of opportunity? What’s the potential for added return when it comes to ESG in debt strategies?

Kerschner: We have a social bond fund, both in the U.S. and in Europe, in mutual fund wrappers. We're looking at possibly extending that into an ETF structure. It’s not that different from ESG in equities. You’re basically funding socially responsible activities, and you're doing the analysis that the return is commensurate with the risk. In an active fund, you're analyzing each issuer and each issuance.

ETF.com: Any misconceptions about ESG investing you’d like to address?

Kerschner: The biggest misconception is the idea that I have to give up something to get ESG, as opposed to ESG actually helps me get something.

Another is that there isn’t enough data to do this properly. That was true a decade or so ago; it's not true today. We can now identify that materiality factor—what is important to an industry, what is material to that industry—and better understand the impact of ESG factors.

Contact Cinthia Murphy at cmurphy@etf.com

 

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