Abstract

Exclusion/negative screening is the most popular filter used to integrate environmental, social, and governance (ESG) criteria into investment strategies. It consists of excluding from the investment universe the instruments issued by companies that don’t meet the criteria defined in the manager’s investment policy. This method is often applied in the passive investment space, where exclusion criteria are combined with index replication. In this paper, we perform an extensive study of the impact of exclusion policies on the financial risks of 493 indices from developed Europe and the US. To address the lack of consensus on ESG criteria, we built three screens based on typical investment policies: a screen based on a few consensus criteria, a more comprehensive screen that incorporates additional climate net zero criteria, and finally an ambitious screen eliminating all companies that have a negative contribution to any of the United Nations sustainable development goals. We show that the effects of the first two exclusion policies on index risks are often very limited, especially when using an optimised reallocation method.

Key takeaways:

• On a sample of 128 European indices, screening leads to an average excluded weight of 9%, 10% and 58% of the portfolio depending on the screen; on a sample of 365 US indices, screening results in an average exclusion of 19%, 23% and 67% depending on the screen.
• We find that applying screens with a naïve (pro rata) reallocation leads to a median tracking error between 0.9% and 4.7% depending on the screen and the sample region. Sector deviations occur mainly in the “Energy” and “Utility” sectors. In terms of fundamentals, exclusions increase exposure to the Fama and French (2015) “profitability” factor, while slightly reducing exposure to “investment” and “value” factors. Applying screens using an optimised reallocation method leads to a median reduction of the tracking error between 0.3% and 1.6%, depending on the screen and the sample region, while also reducing the deviation of factor exposure.
• ESG screening often reduces carbon intensity, but not always. The screening followed by a naïve reallocation scheme results on average in a reduction in the carbon intensity of the indices, up to 54% after the PAB screening on the US sample. However, this systematic reduction does not occur when screening is followed by the optimised reallocation.

Authors

Matteo Bagnara, PhD
Quant Researcher,
Scientific Portfolio ……………………………………….

Shahyar Safaee
Deputy CEO and Business Development Director,
Scientific Portfolio

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