Thought Leadership

Demystifying negative screens: the full implications of ESG exclusions

In this paper we explain the complexities and biases around implementing screens and investigate the pitfalls investors should be aware of.

12/01/2018

Sustainable Investment Team

Screening out investments that do not meet environmental, social or governance (ESG) criteria is superficially simple but fraught with practical challenges. Understanding the complexities and biases screens create before they are implemented and appropriately assessing performance afterward is crucial for investors. In this paper, we investigate the pitfalls when implementing different screens.

Negative screens that sieve investments on environmental, social and governance grounds remain critical to many investors. One-tenth of the assets we manage exclude companies based on their involvement in controversial products or services. Widely-used broader definitions put the share of screened investments closer to one-fifth of all professionally managed assets1. And screening continues to grow, with assets subject to screening having increased by 16% annually over the last four years2.

Of course, negative screening is only one aspect of sustainable investment, and serves a different purpose to activities such as integration and engagement. While the last two are designed to help investors reach better investment outcomes, exclusion policies reflect investors’ choices to avoid activities they consider unpalatable. We firmly believe ESG integration and engagement, effectively implemented, can lead to better investment decisions. We recognise, however, that this is not the only concern for many investors, and so the practical considerations presented by screening almost certainly warrant more attention than they currently receive.

Even if decisions on screens are taken separately from investment analysis, it is vital to understand their effect on investment goals. Typically, this is discussed in terms of the impact of screening on historical performance, a rearview focus that distracts from more important questions. History tells us there is no reason to expect exclusions to systematically reduce long-term returns. But by increasing volatility and inhibiting investment styles, choices over how exclusions are applied and defined can make it significantly harder for managers to execute certain strategies.

The chart in Figure 1 shows the extent to which typical negative exclusions constrain managers. Implementing screens may be mechanical, but assessing their impact on portfolios is a complex task.

In this paper we explore the role of screening, the activities typically targeted, the different ways that exclusions are defined, and their effects on investment strategies. Our aim is to help both those investors with exclusion policies already in place and those considering them to understand the options available and the full implications of their choices.

Click here to read the full report


1 Global Sustainable Investment Review 2016, Global Sustainable Investment Alliance.
2 Global Sustainable Investment Review 2016 as above.

 

Important Information
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document.
The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments.
Derivatives carry a high degree of risk and should only be considered by sophisticated investors.
This material including the website has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.