Why ethical income could be good for your portfolio

Broadly speaking, responsible investment funds employ four different strategies, those that:

■ exclude certain sectors deemed to be objectionable, such as alcohol, arms manufacturing, gambling, pornography and tobacco;

■ look to invest primarily in companies tackling environmental or social problems;

■ seek to persuade companies to address ESG shortcomings and encourage better practice; and

■ integrate ESG factors into all aspects of their investment process.

Environmental considerations might include issues connected to global warming, energy usage and pollution. Social factors include how a company treats its workers, its human rights record, and health and safety measures. Governance issues relate to a company's business ethics, board structure, accounting practices and executive compensation. There can be crossover between these types of approaches, with many funds using some or all those strategies.

There can be substantial risks in not taking an ESG-focused approach, according to Tanya Pein, director of the UK Sustainable Investment & Finance Association. For example, when carmaker Volkswagen (VOW3:GER) was found to have programmed its diesel engines to activate certain emissions controls only during laboratory emissions testing, its share price experienced a steep decline. "There were many funds that suffered an immediate loss as a result of holding Volkswagen and that's not just valuation risk but, from an income point of view, also dividend risk," explains Ms Pein.

However, investors will find it harder to get income from responsible holdings than growth. "Ethical and sustainable funds tend to invest into growth businesses such as those addressing environmental challenges," explains John Ditchfield, partner at Castlefield, which specialises in responsible and ethical investing and runs Castlefield B.E.S.T. Income Fund (GB00B13NP853). "And because they are often growing businesses they don't distribute dividends, preferring to reinvest for growth."

It is also more difficult for responsible income funds to generate dividends than their mainstream peers as many of the large dividend-paying stocks in the UK market come from defensive companies, which are often in sectors such as tobacco, pharmaceuticals, and oil and gas. The Capita Dividend Monitor found that in 2016 just five companies accounted for 38 per cent of the UK dividend total, and these included Royal Dutch Shell (RDSA), BP (BP.) and GlaxoSmithKline (GSK).

Ethical constraints mean many responsible income funds tend to have a small to mid-cap bias - areas of the market less associated with paying a good income. This can be good for growth investors, though, as smaller companies tend to outperform larger ones over the long term, according to Darius McDermott, managing director of FundCalibre.

But there are a few responsible equity income funds, such as F&C Responsible UK Income (GB0033144857), which has a yield of 3.84 per cent, in line with its aim of generating income with the prospect of capital growth. Its manager, Catherine Stanley, achieves this by having a roughly 50/50 split between FTSE 100 companies and small and mid-cap stocks, which she says can be a good area to find companies offering a mix of growth and income.

F&C Responsible UK Income invests in companies whose products and operations are considered to be of long-term benefit to the community at home and abroad. It will generally exclude those considered to be involved with harmful products and practices, or that trade extensively with oppressive regimes. The fund can also invest up to 20 per cent of its portfolio in responsible bonds.

"Under our ethical criteria there are big chunks of the market that we can't buy so we try to extract income from the whole of the portfolio," says Ms Stanley. "You can't do a barbell approach like the more traditional income funds, where you can take a lot of the income from the FTSE 100 and then buy some growth from the other parts of the market. Everything in [our] portfolio has to make a contribution to growth and income."

Examples of holdings that fit this profile include Polypipe (PLP), a manufacturer of plastic piping systems and Sanne (SNN), an international provider of trust and fund administration services.

But, perhaps surprisingly, the fund also holds mining company BHP Billiton (BLT). Vicki Bakhshi, head of governance and sustainable investment at BMO Global Asset Management, EMEA, says: "[The responsible investment] criteria covers both product (what the company produces) and conduct (the company's behaviour). In the case of extractives companies, as well as our product screens covering coal mining, oil sands and Arctic drilling, we also have extensive checks on conduct issues, including community relations, health and safety, environmental performance, and climate change strategies. Companies have to meet our standards on both in order to be investable for the funds, and very few extractives companies do. A small number do pass, including BHP Billiton and Anglo American (AAL), both recognised as having robust, well-established sustainability standards."

This underscores the fact that investors need to do their homework if they are planning to invest in ethical or responsible funds as views on what is ethical can differ, so some ethical or ESG funds might not meet your criteria.

Funds for responsible income

Adrian Lowcock, investment director at Architas, likes Jupiter Responsible Income Fund (GB00B5ZWNT55), which yields 3.43 per cent. It mostly invests in UK companies considered to be responding positively to and profiting from the challenges of environmental sustainability, or that are making a positive commitment to social wellbeing.

"Manager Charlie Thomas is well versed in ethical investing having run Jupiter Ecology fund (GB0005812150) since 2003," says Mr Lowcock. "Jupiter has been successful in the ethical space and for that matter as income investors. Mr Thomas focuses on companies that he considers to have strong management, sound financial strength and an ability to convert a high proportion of their profit into cash. Additionally, he looks for high-quality UK companies that are actively managing their environmental and social impacts. These may include businesses operating in major sectors such as pharmaceuticals, communications, resources and services. There are specific exclusions within the fund: it cannot invest in any company earning more than 10 per cent of its turnover in activities associated with armaments, tobacco, nuclear power and animal testing."

Mr Lowcock also suggests Trojan Ethical Income Fund (GB00BYMLFL45), which has a yield of 3 per cent. "The fund's ethical filter is obtained through the Ethical Investment Research and Information Service (EIRIS), which conducts company research on ethical criteria," says Mr Lowcock. "The fund will not invest in arms, tobacco and fossil fuels. The aim is to provide income over the short, medium and long term, with growth over the medium and longer term."

Although the fund only launched last year its manager, Hugo Ure, has worked at Troy Asset Management since 2009, where he is also co-manager of Troy Income & Growth Trust (TIGT) and assistant manager of Trojan Income Fund (GB00B01BNW49). He has worked in investment since 2004.

Unicorn UK Ethical Income Fund (GB00BYP2Y515) also launched last year and has made a good start - it is in the first quartile of the IA UK Equity Income sector over one year, beating most of its conventional peers. It is run by Fraser Mackersie and Simon Moon, who are also managers of Unicorn UK Income (GB00B00Z1R87), which has an excellent long-term performance record. The ethical fund, however, beats Unicorn UK Income over one year.

"Unicorn has a lot of experience in income investing, particularly in small and mid-cap companies and this ethical fund has done very well since launch," says Mr Lowcock.

Unicorn UK Ethical Income has a yield of 3.9 per cent.

Henderson Global Care UK Income (GB0005030373) is run by Andrew Jones. It aims to provide income with the prospect of capital growth by investing in UK companies that contribute to social wellbeing, and the protection and wise use of the natural environment. "This is a long established fund, yielding around 3.8 per cent," says Mr Hollands.

Its top 10 holdings include many of the large companies that you'd find in a traditional income fund, such as AstraZeneca (AZN), GlaxoSmithKline, Vodafone (VOD), HSBC (HSBA) and Lloyds (LLOY). But it does exclude areas including tobacco and oil majors.

Royal London UK Ethical Equity (GB00B5B49T77) is a growth and income fund that also has similar top 10 holdings to traditional income funds, such as AstraZeneca, Royal Dutch Shell and HSBC. Ethical screening is provided by independent research company EIRIS. The fund excludes gambling, arms, pornography, alcohol and tobacco companies. And it screens out companies on an environmental, human rights and animal testing basis if they do not have adequate policies or systems in these three areas. The fund has a yield of 3.17 per cent.

Ms Pein suggests Kames Ethical Cautious Managed Fund (GB00B7TCPG66), which is run by Audrey Ryan and Iain Buckle. This multi-asset fund aims to provide a combination of income and long-term capital growth by investing in a diversified range of UK equities, bonds and cash, which meet its predefined ethical criteria. These include screening out alcohol, tobacco, gambling, pornography and arms manufacturing companies. It also excludes banks with exposure to large corporate or third-world debt, and companies that have made political donations of more than £25,000 in the past year.

Ms Pein says: "This fund has got a strong integration of ESG factors and has shown good performance over falling and rising markets over the long term with less volatility."

However, its yield of 1.92 per cent is lower than those of some income funds.

Good income from bonds

There are also a number of ethical bond funds that offer attractive yields and are among the top performers in their sectors, beating peers that do not have ethical constraints. These include Rathbone Ethical Bond Fund (GB00B7FQJT36), which yields 5.37 per cent. It is among the 10 best performers in the Investment Association (IA) Sterling Corporate Bond sector over five years and in the first quartile over one year, beating most of its conventional peers.

This fund invests in quality investment-grade bonds and excludes those issued by companies involved with mining, arms, gambling, pornography, animal testing, nuclear power, alcohol and tobacco. All its holdings must have at least one positive environmental, social or corporate governance quality.

Analysts at research company FundCalibre say: "This fund typifies stable management, with manager Bryn Jones having been there for over 10 years. It has managed to outperform regardless of its ethical constraints, illustrating that income and ethics can be combined without sacrifice. It is a solid core investment-grade fund."

IC Top 100 Fund Royal London Ethical Bond (GB00B7MT2J68) is in the top quartile of the IA Sterling Strategic Bond sector over one, three and five years and has an attractive yield of nearly 4 per cent. It aims for a combination of income and capital growth by investing mainly in investment-grade UK bonds that meet predefined ethical criteria, avoiding ones from issuers involved with alcohol, armaments, gambling, tobacco, pornography and animal testing, as well as ones that have a high environmental or human rights impact. It has a very reasonable ongoing charge of 0.51 per cent.

Ms Pein highlights Liontrust Sustainable Futures Corporate Bond Fund (GB0030029069). "The team who run the fund are one of the largest sustainable investment teams in the City, with one of the longest track records," she says.

The fund has a yield of 3.3 per cent.

Fund yield and performance

Source: Morningstar as at 06/05/2017