Negative screening has been a longstanding constant of sustainable investing, with most strategies employing some form of exclusionary objectives. But are investors better off owning, influencing and engaging with these companies to help steer the ship?
Nearly any modern ESG fund will avoid alcohol, tobacco and gun manufacturing companies as the target market’s values preclude holding these types of companies. It is also commonplace to see fossil fuel-related exclusions, which has contributed to an increasingly adversarial political environment for supporters of sustainable investing.
There is increasing scrutiny on company exclusions in ESG strategies, and it has led to many questions on its ability to drive environmental and societal change. For example, by divesting from a company, a fund/individual sacrifices their ability to be an active owner and have a say through proxy votes or meetings with management on sustainable investing topics.
Further, ESG ratings agencies tend to promote this behavior by rewarding companies and funds with the lowest exposure to both carbon emissions and riskier ESG business lines. It’s commonly argued that the fossil fuel industry is one of the biggest offenders of carbon pollution, yet we know our economy remains dependent on them and cannot support an immediate transition.
So is it better to hold and engage? For some the answer is unequivocally “no.” But I would argue there is room for choice and reimagination.
The counter argument is that many of these companies don’t care to change, and no amount of engagement is worthwhile. This argument assumes all riskier/low scoring ESG companies are irredeemable bad faith actors. Likely true in some cases, but it’s worth the effort to find out, especially if there can be both outsized investment returns and ESG impact along the way.
Some firms are adjusting and introducing strategies that rely more heavily on engagement. Parnassus Investments, a long-time standard bearer in the ESG investing space, is reconsidering its stance on excluding nuclear companies. Newer firms in the public investment space like Engine No. 1 have launched ETFs that focus on active ownership instead of exclusions.
It will be interesting to see how consumer preferences unfold and further shape asset manager policies.
Is active ownership better?
Engagement with companies regularly, or active ownership, should be an important part of the ESG investor toolkit. There are two ways investors can engage with companies as a shareholder, proxy voting and direct conversations with management.
As a shareholder, you are generally entitled to vote in accordance with your ownership interest. You can use this ownership power to help shape the board, impact governance policies, and submit proposals on ESG matters. Additionally, shareholders can also engage with management through various mechanisms, including direct conversation.
With a seat at the table, sustainably aligned investors can push for policies to reduce ESG risk whereas divestment-oriented strategies can only withhold capital that is likely to be filled by non-values-based investors. For investors that use their economic ownership to push for change, moving the needle on a poorly scoring ESG company could have a greater impact than simply investing in a company that already scores well. Whether investors can move the needle is at the heart of the debate around the efficacy of engagement versus exclusion.
Choosing an approach
Personal preferences are the major driving force in ESG investing. For those passionate about values aligning with their investments, direct indexing or an exclusion-based ESG fund are worthwhile investment options to consider.
Whether following an explicit ESG index methodology or employing custom exclusions, a direct indexing strategy is the most personal and customizable portfolio solution for those that want a tailored portfolio. A more robust, modern ESG strategy is likely to utilize some negative screens and actively engage with their investment holdings. For investors deciding if a given ESG strategy is right for them, a few key questions are:
1) Is the portfolio exclusion methodology appropriate for my values and diversification needs?
2) Am I comfortable with the return profile relative to a market index that results from the screening methodology?
3) Does the manager practice active ownership and engage with their holdings to manage ESG risk and drive positive outcomes?
See also: – Five ways companies can improve ESG approach
The industry continues to provide innovation depending on an ESG investor’s personal preferences. While negative screening has been a mainstay for decades, there are now more tools available to make an impact and drive attractive reward-for-risk outcomes within a portfolio.
Investors are best served by exploring the solution that best meets their values.