Oil shares lose appeal in income funds

Royal Dutch Shell shares pay a dividend yield of 6.2 per cent, beaten only by Wm Morrison and J Sainsbury among FTSE 100 stocks, according to Thomson Reuters. Anglo American, BHP Billiton and BP also feature in the top 10, offering 6 per cent or more. That appears to make the energy sector a plum one for investors looking for income.

Thanks to the dominance of financial and energy stocks in the FTSE 100, even the index yields 3.9 per cent, easily beating the 1.6 per cent on a 10-year gilt.

Of course stocks come with risks - energy stocks perhaps more than most. The falling oil price has led energy company share prices on a merry dance, with lower share prices boosting dividend yields. Shell is down 17 per cent since the beginning of September, with its proposed takeover of BG Group last week contributing to that fall.

Some would say the share price performance is of little concern provided the dividends keep coming - but will they?

Energy companies, notably BP and/or Shell, feature among the top 10 holdings of many UK equity income funds, suggesting professional fund managers are sanguine about dividend prospects (or just do not want to take the risk of departing too far from index weights). But the oil majors are conspicuous by their complete absence from the portfolio of the UK's best known equity income fund manager Neil Woodford, who left fund group Invesco Perpetual a year ago to run his own funds.

This is on a view that the dividends are not sustainable in the longer term, because they are no longer being paid out of cash flow but by raising debt or selling assets. Stephen Lamacraft, a fund manager on the Woodford Equity Income fund, wrote in a blog in late January that, with the oil price likely to remain depressed for some time, "companies will either have to cut capex, and by implication future growth, or the dividend".

Being out of oil has not done the Woodford fund any harm and probably a lot of good: it has returned 19.5 per cent over the past six months on a total return basis, against 12.6 per cent for the FTSE 100 and 15.7 per cent for the equity income fund sector.

Dividend sustainability is only part of the risk for investors in energy companies though. Longer term there is the bigger issue of "stranded assets" - the argument that 60-80 per cent of coal, oil and gas reserves of publicly listed companies must stay in the ground if the world is to have a chance of not exceeding global warming of 2°C.

The market has yet to be convinced by this as it is not priced into the shares (or debt costs) of extractive companies, but investors betting that will continue to be the case must also bet against any concerted government action to limit carbon emissions. There are difficulties though for fund investors wanting to be sure of avoiding exposure to the energy sector - whether for financial reasons or in sympathy with the divestment campaign some institutional investors have signed up to.

Index providers offer a variety of low carbon or fossil free indices, but among the 5,000 plus exchange traded funds on the market, there are a handful at best that track such indices. An internet search revealed only two, from iShares and State Street, both tracking the global MSCI ACWI ex Fossil Fuels Index, and both quoted on the New York Stock Exchange.

Such products are aimed mainly at institutional investors rather than individuals. But they offer reassurance that forgoing exposure to the fossil fuel energy sector does not automatically involve a performance penalty. Data from MSCI show its fossil free index has outperformed its parent index, MSCI ACWI, both on a cumulative basis since launch and for the past three calendar years. In 2013, for example, the fossil free index returned 18.7 per cent, in dollar terms, versus 16.8 per cent for the parent index.

In the UK, BlackRock teamed up with FTSE Group a year ago to launch the FTSE ex-Fossil Fuels Index Series, but there are no accompanying ETFs as yet.

ShareAction, the UK-based movement for responsible investment, reported in a blog calling 150 product providers in a bid to find a low fee, fossil-free index tracking savings product. It had no luck.

If others come round to Mr Woodford's view of oil companies, or become convinced of the stranded asset risk, ShareAction may have better luck next time.

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