This the first of a series of Posts covering the seven broadly recognised Responsible Investment Strategies.
Exclusions, also referred to as negative screens, is the most dominant responsible investment strategy in New Zealand according to the Responsible Investment Association Australasia’s (RIAA) Responsible Investment Benchmark Report NZ 2019. Based on RIAA’s report 44% of Funds Under Management in New Zealand employ a negative screening approach.
Exclusions is the oldest form of sustainability investing and has been associated with those investors looking to manage their reputation risk. Modern forms of negative screening have been around since the 1960’s. The Philosophy dates-back to the 18th century.
Negative screening strategies exclude certain sectors, companies, or countries from a Fund’s investment universe.
Exclusions are often subjective decisions based on an investor’s values or are undertaken to avoid commonly called controversial business practices and products. Examples of controversial activities are, Tobacco, Alcohol, Weapons, Gambling, Adult entertainment.
Other areas frequently excluded are animal testing, nuclear energy, genetically modified organisms, with the latter two often barred in Europe. In recent years, it has become more common to exclude the worst climate offenders, including thermal coal and controversial oil and gas companies.
Exclusions can also be based on behaviour that is incompatible with sustainability standards or severe environmental or human rights violations. The Ten Principles of the UN Global Compact are often used as a guide in deciding which areas warrant exclusion.
Although Negative Screening appears to be a relatively straightforward strategy to implement, investors must ask themselves some difficult questions.
The devil is in the detail, and exclusions are no lay down misere. There is a high degree of ambiguity.
Exclusion lists force investors to make absolute yes or no decisions, which can often mask the subtleties of some corporate activities. For example, a common industry excluded in ESG portfolios is tobacco. However, where does one draw the line with industries such as weapons manufacturing? Should only nuclear weapons manufacturers be excluded? What about handgun manufacturers?
The Exclusion process broadly involves the following steps. Investors need to determine:
- Activities to avoid
- Materiality thresholds or the said activities (e.g. at least 5% of revenues).
- The investment universe is then screened, relying on a database. An immediate implementation issue is over quality of databases and variation in databases between providers (a subject of a future Post, highlighted now that subtleties and nuances excess in implementing).
- Companies breaching thresholds are removed from the investable universe and existing portfolios. See below for materiality.
- Repeat with some frequency (e.g. quarterly or annually for Index providers and as stocks are research for active managers).
In my mind, a sound Responsible Investment (RI) philosophy and framework needs to be established first. An RI Policy Document covering such should be developed and approved by the relevant Board. Key exclusions would likely be included in the Policy.
I personally believe RI starts with Environmental, Social, and Governance (ESG) integration (ESG integration is another RI investment strategy which will be covered in a future Post).
An exclusion list is then developed based on the RI Philosophy (set of values) in the first instance and overtime based on the ongoing ESG research.
Exclusions without a philosophy or ESG research is management of reputation risk only, it has no solid foundation. A wide sweeping corporate marketing statement does not constitute a RI Policy.
Materiality and Business Activities
Exclusion lists not only forces one to make absolute decisions on industries, they also force one to make absolute decisions on companies that have diversified businesses.
Therefore, a key question to answer before applying negative screening to a portfolio is where to draw the line. This entails two aspects: materiality thresholds and the nature of business involvement.
Materiality is relatively straightforward. Does an investor wish to eliminate issuers with any involvement at all in the excluded activities, or is there a tolerance for a small portion of revenues (e.g. no more than 5%) to arise from these areas?
The answer is personal. There is a trade-off involved between the strictness of the threshold and the financial impact that may result from the exclusions.
The second point to consider is the nature of involvement in a given business activity.
A key distinction is between manufacturing and distribution.
In the case of alcohol, for example, should investors only exclude companies that produce alcohol or also those that derive a substantial portion of their revenues from it? And if they choose the latter, how exactly should they define a ‘substantial portion’? And if they are excluding alcohol manufacturers from their universe, what about the firms selling it, such as major retailers? Hotel Chains?
Therefore, it is important to understand what an exclusion will imply in practice. Investors need to be comfortable with the results. This can be challenging where there is a wide range of stakeholders. Understanding the trade-offs involved is critical to avoiding surprises later.
The devil also lies in the detail when it comes to implementation.
This article by Man Numeric highlights the complexity of issues to consider in applying exclusions to the controversial weapons sector. Providing a good discussion in relation to materiality and business activities.
Excluding a company rarely leads to its product being removed from the market. And excluding entire sectors for non-financial reasons can have a meaningful impact on the risk/return characteristics of a portfolio.
Exclusions are most suitable for investors with a clear vision and set of values on which products or behaviours they and their stakeholders wish to avoid. For example, charities with well-defined values and beliefs and health insurers that wish to exclude companies making products that are detrimental to general health.
Best in Class
While exclusion strategies adopt a negative approach, best-in-class strategies adopt a more positive stance, choosing to invest in the firms with the best ESG practices in a sector rather than deliberately avoiding certain areas. These strategies are based on the premise that firms with the best ESG practices are likely to outperform over the long term. Best in Class will be the subject of a future Post.
ESG investing is a broad field with many different investment approaches addressing various investment objectives.
At a higher level ESG investing can be broken down to three main areas that each have their own investment objective:
- ESG integration, in which the key objective is to improve the risk–return characteristics of a portfolio.
- Values-based investing, in which the investor seeks to align their portfolio with their norms and beliefs. (i.e. Exclusions)
- Impact investing, investors use their capital to trigger change for social or environmental purposes e.g.to accelerate the decarbonisation of the economy.
Best practice includes exclusions, ESG integration with a focus on best-in-class, and Impact investing, a full array of Sustainable Investing strategies.
Crucially it requires an understanding of how to integrate ESG criteria into the investment process to capture the full value of ESG.
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