Exclusion Lists vs. Best‑in‑Class ESG Approaches

Navigating the world of sustainable investing can feel overwhelming, but it starts with simple choices.

Two foundational strategies, exclusion lists and best-in-class approaches, offer distinct paths to incorporate Environmental, Social, and Governance factors.

These methods help investors align their capital with personal values while seeking financial returns.

Understanding Exclusion Lists

Exclusion lists, often called negative screening, are the most common ESG tactic.

This approach involves removing companies or sectors from investment portfolios based on predefined controversial activities.

It is a lighter-touch method that signals investor preferences without complex analysis.

Common exclusion criteria span various categories to avoid harmful impacts.

• Weapons and Armaments: This includes controversial weapons like nuclear power components.
• Fossil Fuels: Oil, gas, and coal industries are often excluded due to environmental concerns.
• Vice Industries: Tobacco, alcohol, gambling, and pornography are typical exclusions.
• Social Violations: Human rights abuses, child labor, and corruption fall under this.
• Environmental and Other Issues: Examples are intensive agriculture or gold mining with high damage.

The process starts with a parent index and removes unacceptable securities by business activity.

Then, it reweights the remaining ones, often by market capitalization.

This leads to minimal deviation from the parent index, making it a straightforward choice.

However, it eliminates engagement opportunities with excluded firms, which can be a drawback.

Exploring Best-in-Class Approaches

Best-in-class approaches focus on selecting or overweighting companies with the highest ESG ratings within their sectors.

Even in controversial industries, this method rewards leaders for relative outperformance.

It emphasizes sector-relative improvement rather than absolute avoidance.

The typical process involves a few key steps to ensure rigor.

1. Apply initial exclusions for severe violations, such as controversial weapons or coal.
2. Rank the remaining companies by ESG scores, adjusting for sector differences.
3. Select top performers, like the top 25-75% by market weight, and optimize to reduce tracking error.

For example, in the auto sector, a best-in-class strategy might include BMW due to strong ESG ratings, despite its combustion engines.

This contrasts with strict exclusions that would remove such companies entirely.

MSCI uses sector-adjusted scores based on SIC codes and business segment exposure for accuracy.

Key Differences Between the Strategies

The core differences lie in focus, strictness, and impact on portfolios.

Exclusion lists aim to avoid worst offenders with absolute negatives.

Best-in-class methods reward relative leaders in any sector for improvement.

Exclusions are ubiquitous, often serving as an industry benchmark for values alignment.

Best-in-class often combines with positive tilts to overweight high scorers for enhanced impact.

Advantages and Drawbacks

Each approach has its pros and cons, shaping investment outcomes differently.

For exclusion lists, the advantages are clear and practical.

• Pros: Easy to implement, aligns directly with values, and maintains low tracking error.
• Cons: No engagement for improvement, may exclude firms that could change, and lists evolve over time.

Best-in-class approaches offer different benefits and challenges.

• Pros: Drives sector-wide improvement, captures leaders, and can leverage ESG momentum for returns.
• Cons: Higher deviation from indices, invests in moderate-ESG firms, and faces data reliability issues.

General challenges in ESG investing add complexity to both methods.

Data quality, threshold setting, and regulatory flux, like the EU Taxonomy, require constant attention.

Exclusions often correlate highly across funds, such as with Norges Bank, indicating common standards.

Practical Insights and Examples

Real-world applications and numbers bring these strategies to life for investors.

Indices show that the lightest best-in-class captures 75% of parent weight, while strictest versions take 25%.

MSCI scores rate best-in-class firms between 76-95 out of 100, using 163 GICS sub-industries for precision.

Simulations demonstrate that removing coal, oil, or gas subsectors can significantly impact portfolio performance.

Examples like klimaVest using exclusions via due diligence highlight practical implementation.

Market context shapes how these approaches are combined for optimal results.

Exclusions are often the first step in ESG indices, followed by best-in-class for added rigor.

The EU Taxonomy mandates minimum safeguards, pushing investors toward more integrated methods.

A shift from process-based screening to outcome-focused investing is emerging in the market.

Client requests drive adoption, making it essential to monitor evolving norms and expectations.

Other ESG Approaches for Context

Beyond exclusion and best-in-class, several related strategies enrich the sustainable investing landscape.

• Positive screening or tilt: Overweights firms meeting specific ESG thresholds or diversity goals.
• Divestment: Complete withdrawal from sectors like fossil fuels for ethical reasons.
• ESG integration: Incorporates ESG factors alongside financial analysis after initial screening.
• Thematic or impact investing: Targets measurable positive outcomes, stricter than general ESG.
• EU frameworks: Ensure minimum safeguards through due diligence, such as human rights protections.

The CFA Institute identifies six common approaches, including negative screening, positive screening, best-in-class, ESG integration, standards-based, and thematic investing.

Methodologies like MSCI ESG Ratings use sector-relative scores adjusted for externalities, such as carbon intensity.

Tilting strategies boost weights for high-ESG firms and cut low ones post-exclusions for balance.

Navigating the ESG Landscape

Choosing between exclusion lists and best-in-class requires thoughtful consideration of your goals.

Exclusion lists offer a straightforward way to avoid harm and align with core values.

Best-in-class approaches encourage progress within industries, potentially driving broader change.

For practical help, start by assessing your risk tolerance and values alignment.

Use exclusion lists to eliminate clear conflicts, then apply best-in-class for nuanced selections.

Monitor data quality and regulatory updates, as ESG standards continuously evolve.

Engage with financial advisors to tailor these strategies to your portfolio's needs.

Remember, sustainable investing is not just about avoidance but fostering positive impact.

By blending these approaches, you can create a resilient, value-aligned investment strategy for the future.