26 S K E P T I C I S M T O O P T I M I S M
Socially responsible investing occurs along a continuum that can be reduced to roughly four degrees of implementation (Figure 7). Figure 7. The spectrum of SRI investing implementations
Nega ve Screening
Tilts or “Best in Class�
“Bo om-up� ESG Integra on
Impact Inves ng
Source: Balentine
• Negative screening, or ethically motivated divestment, is the oldest and simplest form of ESG investing. It is exclusionary in nature and tends to hamper portfolio performance since the investment universe is smaller while simultaneously creating excessive tracking error to the investor’s benchmark. Exclusionary screens impose upon investors a constrained portfolio, one that is theoretically suboptimal and more idiosyncratically risky than an unconstrained offering. Consequently, lingering thoughts that ESG investing involves only ethical divestment may delay its broader adoption.7 • ESG tilts, or “best-in-classâ€? incorporation, do not necessarily require the omission of securities; they may instead involve the reweighting of those securities to favor those with higher ESG composite scores.8 The investor may place constraints on sector deviation or factor deviation9 to reduce portfolio tracking error to the benchmark, and will generally extend a level of tolerance to otherwise ESG-poor companies to hold deviations from index characteristics to a minimum. Best-in-class integration may also screen out those ESG factors that remain intolerable; it is not mutually exclusive with the more restrictive negative screening. Closely related but more in-depth (and costly) “bottom-upâ€? ESG integration tends to take a deeper look at any number of ESG factors (typically at the security level), and how those factors may or may not affect the profitability of an organization. Both methods are predicated on one of two (or both) premises: – ESG integration can improve portfolio performance on an absolute basis. – ESG integration can improve portfolio performance on a risk-adjusted basis. 7 See https://www.oecd.org/cgfi/Investment-Governance-Integration-ESG-Factors.pdf. 8 See https://www.parametricportfolio.com/insights-and-research/understanding-esg-screens-and-tilts. 9 See https://www.msci.com/documents/1296102/1339060/MSCI-FactorESG-TargetIndexes-marketing-factsheet.pdf/997a61b0-7094-469c-86a623161b6435c7.
