Fossil-fuel screen coupled with modified approach leads to promising sustainable dividend portfolio
For investors who desire protection for turbulent times as well as income even in low-yield environments, low-volatility high-yield (LVHY) strategies can offer a good solution. But given the extensive presence of utilities and energy companies in high-dividend portfolios, they could be problematic for those with an eye on sustainability.
But according to new research from Genus Capital, staying true to one’s values doesn’t have to come at the expense of performance. In fact, a fossil fuel-free strategy might actually work better.
“Unfortunately for fossil free investors, many of the companies that pay high dividends are carbon-intensive utilities or companies engaged in producing energy, tobacco or other controversial consumer staples,” the firm said in a new report.
The report noted that the S&P TSX Composite High Dividend Index has a 30% weighting toward energy companies, as well as 14% in utilities. Along with consumer staples, the sectors represent over 44% of Canadian dividend stocks and 42% of MSCI World dividend stocks that don’t meet Genus’s value screens for fossil-free strategies.
“This means we have to take a modified approach to a sustainable dividend portfolio,” the report said.
The firm’s study began with a hypothetical 35% TSX composite, 65% MSCI World benchmark, tracking its performance over the period covering July 2006 to July 2019. From there, it optimized the portfolio through a series of backtests, starting with the addition of a fossil-free screen, along with a minimum portfolio dividend requirement of 4% and other parameters to replicate a high-dividend portfolio.
In the next backtest, it applied its proprietary quantitative Genus alpha scoring system, optimizing to boost the average alpha score within the portfolio while minimizing tracking error. “Performance increases significantly as a result of the Genus alpha scores,” the report said.
To offset the constraining effect of the fossil-free screen on the portfolio’s investable universe of securities, the next backtest was performed with a more relaxed 3.25% portfolio dividend requirement. Concentrations in higher-alpha stock positions were then increased, slightly boosting the portfolio’s active return.
The report noted that fossil-free companies’ tendency to focus on growth and the long term results in lower dividend yields for many sustainable stocks with higher alpha scores. To increase the portfolio’s selection capabilities, the minimum individual holding yield requirement was reduced to 1%, increasing the portfolio’s selection possibilities while maintaining its minimum 3.25% yield level.
The following backtest was run with a slightly higher maximum beta threshold of 0.8, which the report said would position it for better long-run performance while still being much lower-beta than the market. Finally, an additional tilt toward momentum was found to amplify the performance of a fossil-free dividend portfolio. “For this portfolio, annualized return and alpha are boosted, while the downside capture is decreased slightly,” the report said.
The results showed that the Enhanced Fossil-Free Dividend strategy dropped to a much lesser degree than the 35% S&P TSX/65% MSCI World benchmark during the late 2008 downturn, delivering superior performance during the global financial crisis from 2007 to 2009. It then appreciated at a similar rate during the 2009-2010 upswing.
“We have only recently integrated this enhanced strategy into the Genus Fossil Free Dividend Equity Fund,” the report said, noting that it has not outperformed the benchmark for a long-enough time to be statistically significant. “However, based on the backtests and live performance, we are optimistic.”