How Does Negative Screening Effect Your ESG Investment?
This is part one in a three part series.
Today we'll focus on negative (or exclusionary) screening associated with ESG investing.
Parts 2 & 3 will focus on:
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Positive Screening
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Active vs. Passive investing (specific to ESG investing)
We'll talk about:
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What is negative screening?
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Does it effect performance?
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Where is it the most effective?
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Where is it the least effective?
What is negative screening?
Negative or Exclusionary screening is simply choosing companies or sectors to exclude from your portfolio based on your values.
Negative screening is probably the easiest and most direct way an investor can align their money with their values.
Most commonly, this has meant avoiding investments in:
alcohol -------------------------------------------->
tobacco --------------------------------->
gambling ------------------------>
firearms -------------->
oil ----->
Negative screening is more common than you may think. Many big institutional investors have setup negative screens.
Source: Schroders - Demystifying Negative Screens 2
This exclusionary technique brings us the most commonly heard critique with sustainable investing...
"If you limit the number of companies you can invest in, you're going to limit your performance."
You've probably heard this before right?
Does Negative Screening effect performance?
Jon Hale, head of Sustainability research at Morningstar stated,
"Academic research has shown that stock exclusion trends tend to be a negative factor in performance." 1
So, yes... Negative screening does effect performance.
But...
It is very important to understand that when it comes to investing,
You will rarely find absolute answers!
With ESG investing, I suggest you get used to answers that come in shades of grey rather than black and white.
While Hale states that exclusion based screens can have a negative effect on performance, he also states that
"the ESG performance of companies appears to be something that can be used to generate value in a portfolio." 1
We'll talk more about this in our Positive Screening article.
It's important to understand that with negative screening,
the impact varies based on what what is screened...
Where is negative screening the most effective?
Most importantly, negative screening has the greatest effect when it comes to your personal values.
You can't put a price on feeling good about your investments.
However, we've already learned that purely exclusionary based screens can have a negative effect on portfolios.
We'll look at which screens potentially have the "least" negative effect.
Source: Schroders - Demystifying Negative Screens 2
The above image shows the Tracking Error of each of these screens as compared to the traditional index.
This means, how much did the negative screen effect the potential returns of the portfolio compared to the index.
What this means to you is:
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your portfolio could be negatively screened to eliminate:
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Pornography
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Gambling
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Alcohol
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Fur
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Tobacco
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Eliminating these categories could potentially have a minimal effect on your portfolio performance.
If however you want to eliminate:
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Fossil Fuels
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Weapons
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Nuclear power
You may need to consider ways to offset this potential performance loss.
For ideas on how, check out parts 2 & 3 in this series...
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Active vs. Passive investing (specific to ESG investing)
Where is negative screening the least effective?
What we're really talking about here is which negative screens have the most (potentially) negative effect on your portfolio.
Which negative screens will require the most work to offset.
Let's go back to those common screening categories.
Just like earlier, you'll notice that depending on what you choose to negatively screen, you may potentially eliminate 0 - 10+% of your portfolio holdings. (cumulatively more when you negatively screen for multiple categories)
Source: Schroders - Demystifying Negative Screens 2
Adding to this, depending on which categories you eliminate you may end up cutting some of the largest dividend income producers in your portfolio.
As you continue to add negative screens to your portfolio, there comes a point where you may need to compensate for this change in portfolio composition in some way.
This compensation is one reason why I believe that in certain circumstances, actively managed funds may be a better fit for ESG investments.
Until now, we've strictly been talking from a portfolio perspective.
But... Since ESG investing is largely values based, shouldn't we also talk about the Values Perspective?
This is where I believe negative screening is the least effective.
Do you want to do less bad, or do you want to do more good?
If you truly want to effect change, you cannot do that through excluding companies.
You instead need to take an active ownership approach by buying companies that need help and effecting change from within.
Think if you had a rebellious teenager. Do you solve their problems by disowning them or by rolling up your sleeves and getting involved in their lives?
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Negative screening does have it's place in your portfolio. However you must consider that:
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It may have some negative performance consequences.
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It may require some type of portfolio compensation to offset the investments that were removed.
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While negative screening is the easiest way to align your portfolio with your values, it is not the most effective at creating a positive impact.
What this all means for you:
Investing with your values is a journey, not a math exercise.
If you don't know where to get started, I would encourage you to check out our Ultimate Guide to ESG Investments.
If you prefer to delegate, feel free to schedule a phone call. We're happy to help...
We're a different kind of financial firm than you may be used to.