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How to add ESG factors to your portfolio? Positive/ Best-in-class screening

The best-in-class approach involves selecting top companies in terms of ESG metrics. These companies are actively making an effort to improve their ESG impact. Best-in-class screening rewards them by overweighting these companies in their portfolios. 

This method has the advantage of including companies that operate in industries that are not necessarily ESG-friendly. To illustrate, the energy sector is one of the worst sectors for sustainable investment due to its devastating effects on the environment. The energy sector represents 10.2% of the total nominal gross domestic product in Canada and represents over 12% of the S&P/TSX Composite Index as of March 31, 2021. Excluding this sector would mean a substantial deviation from the main Canadian market index. Positive screening also has the benefit of encouraging companies to adopt better ESG guidelines because that would make them more competitive compared to their peers. 

However, implementing a best-in-class screen is time-consuming, if done without the use of third party ESG ratings. Analysts must examine each company in the universe and rank them in terms of sustainability. Third party such as Sustainalytics, offered by InoAdvisor as an add-on, can considerably improve this tedious process. We provide a breakdown of the ESG Risk Rating, Notable Material ESG Issues, Product Involvement and a list of Controversies on over 12,000 companies worldwide. 

Implementation 

Best-in-class selection can be done on an absolute basis, when companies are selected based on their outperformance in terms of ESG characteristics in the entire universe, or on a relative basis, when companies are compared to their competitors within the same industry/sector and are selected based on their superior ESG ratings. 

We focus on the relative basis as it is the most used method. The steps are as follows: 

1. Assign an ESG rating to each company in the investible universe

Each company
has to be analyzed and assigned an ESG score in order to compare companies across sectors or industries and determine which ones are the best in terms of ESG performance. An alternative to this lengthy process is to use readily available ESG data providers.

2. Rank the stocks from best to worst in each sector

Classify the companies in each sector or indus
try from best ESG scored companies to worst ESG scored companies.

3. Overweight the ESG leaders and underweight the ESG losers in your portfolio

Depending on your strategy, you can overweight top ESG companies and underweight bottom ESG companies or only include top ESG companies in your po
rtfolio

Illustration 

Using the InoAdvisor’s screener, we find the best-in-class stocks in the Canadian energy sector. 

We apply the following filters to stocks listed on the TSX: 

  • Energy sector, 
  • Market capitalization of $1 billion or above, 
  • Current SP Score of 5or higher and, 
  • Positive Return on Capital. 

We get a list of 11 Canadian energy companies, ranked from lowest ESG risk exposure to highest ESG risk exposure. Portfolio Managers using the best-in-class approach will favor the lowest ESG risk exposed companies, which implies a higher ESG rating, to their portfolios. 

For a list of this screen, click here. Contact your account executive if you are not already subscribed to our new ESG add-on. 

Pembina Pipeline Corporation (PPLis the top company in our screen. Despite a high Overall Exposure Score of 44.3, the company’s ESG Risk Rating stands at 20.2. Iis able to considerably manage its ESG risk through its ESG measures. From their Sustainability Report 2020, Pembina 

  • Focuses on safe working conditions, with their safety records continuously exceeding the industry average, 
  • Is once again recognized as one of Canada’s Top 100 Employers, 
  • Advanced the implementation strategy for their Carbon Stand as well as their Inclusion and Diversity Stand, 
  • Demonstrated support to the communities in which they have a presence, with a direct investment of $10 million in 2019, a 30 percent increase over the prior year.

The Best-in-class ESG Integration technique helps investors align their values and enhance their risk-adjusted returnsUsing third-party ESG data improves the integration process by reducing the time and effort required to analyze how sustainable companies are. This method encourages companies to consider ESG issues in addition to their bottom-line because mindful investors favor ESG-friendly companies.

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.