Intelligence

How to add ESG factors to your portfolio? Negative/ Exclusionary screening

There’s a variety of methods to incorporate ESG factors into your portfolio. In this blog post series, we go over each of them, consider their benefits and drawbacks, and see how they can be implemented using Inovestor for Advisors.

Today, we look at negative, also called exclusionary, screenings. Negative screening entails the exclusion of companies, sectors, or countries based on specific activities that go against investors’ ethics or values. 

In its early days, ESG exclusionary screens were mostly implemented to target religious investorsInvestors would screen out companies involved in products that went against their faith. For example, tobacco, alcohol and gambling are among the sectors prohibited in Islamic Finance. Nowadays, negative ESG screens are used by a broadeaudiences, filtering out companies involved in a variety of values-based factors, like controversial weapons or animal testing. 

It can also be applied to specific countriescompanies and individuals. Many countries, including Canada, impose sanctions on other countries, organizations, or individuals that are responsible for gross violations of internationally-recognized human rights, such as extrajudicial killings or nuclear programs. These sanctions prevent trade, financial transactions or other economic activity with the sanctioned countries. Portfolio managers can proactively exclude countries and companies they believe are acting in unethical ways and are expected to be sanctioned. 

Negative ESG screening is the easiest and most widely-used way to implement ESG investing. By simply excluding companies involved in activities investors condemn, they are presented with a broad investible universe cleansed from companies directly involved in unacceptable activities. And, in good news, negative ESG screening does not wipe out the majority of the investible universe. As such, this is a good introductory method to ESG investing. Unlike the other methods, idoes not involve extensive research to identify what each company is doing to be more sustainable and mitigate their ESG risks. 

The main criticism of exclusionary screens is that investors “wash their hands rather than attempt to solve the problems. It is a passive way of dealing with ESG issues. Investors may not supporting unethical companies financially, but they are not encouraging them to take more ethical approaches, either. Additionally, within ESG filters, companies not involved in immoral products are all on the same level, without actually rewarding more sustainable ones.  

Implementation 

As mentioned, exclusionary screening is the easiest method of incorporating ESG to your portfolio. Here are the steps to implement negative screening: 

  1. Define products, sectors or countries to exclude

It is important to know which products, sectors or countries your clients don’t want in their portfolio. Adding the definition of each negative product, sector or country in the Investment Policy Statement (IPS) as part of the Know Your Client (KYC) procedures helps portfolio managers or investment advisors during portfolio construction or rebalancing. 

2. Filter out all companies knowingly involved in these products  

Once you have identified and defined which products, sectors or countries to exclude, you can screen out all companies that are directly involved in negative products. We offer a screener with ESG data, including controversial product involvement of companies. It removes the manual and time-consuming task of identifying these companies. 

3. Apply additional screens and models to the ethical investible universe 

After removing companies involved in negative products, additional financial filters can be applied or you can apply a model to your “ethical” investible universe to create your portfolio.
 

Example 

Inovestor for Advisors’ screener has a new feature for subscribers who have the ESG add-on. It allows users to add ESG screens on top of other StockPointer’s filters as an overlay. We used this newly launched ESG overlay to implement a negative screen.

 We applied the following filters to companies listed on NYSE and NASDAQ: 

  • ESG exclusionary criteria: Companies not involved in “sin products” including tobacco, adult entertainment, gambling, abortion, contraceptives, human embryonic stem cell and fetal tissue. 
  • Market capitalization of $10 billion and above, 
  • A positive Net Profit, 
  • Revenue of $100 million and above, 
  • Return on Capital of 10% and higher, 
  • Economic Performance Index (EPI) of 1 and above, 
  • EPI 12-month change of 1 and above and 
  • Current SP Score of 50 and higher, 

Our final screen consists of 21 large-capitalization companies with high economic performance and purified from “sin” products.

Make sure to contact your account executive to add Sustainalytics’ ESG data if you’re not already subscribed. For a full list of this screen, click here: ESG negative screen.

Its ease of implementation and its usefulness to align investors’ values with their investments make exclusionary screening the most commonly used technique to include ESG factors in the portfolio.