Synopsis:  This article explains the concept of exclusionary/divestiture strategies, one of the four principal sustainable investing strategies, the various exclusions that are typically considered by investors as well as the challenges associated with targeting specific exclusions, in particular when investing in managed funds such as mutual funds and ETFs.

Introduction

Exclusionary strategies (sometimes also referred to as negative screening) involve the exclusions of companies or certain sectors from portfolios based on specific ethical, religious, social or environmental guidelines or preferences. Traditional examples of exclusionary strategies cover the avoidance of any investments in companies that are fully or partially engaged in gambling and sex related activities, the production or manufacturing of alcohol, tobacco or firearms, or even atomic energy. These exclusionary categories have been extended in recent years to incorporate additional considerations, for example, firms that are the subject of serious labor-related actions or penalties by regulatory agencies or demonstrate a pattern of employing forced, compulsory or child labor, or firms that exhibit a pattern and practice of human rights violations or are directly complicit in human rights violations committed by governments or security forces, including those that are under US or international sanctions for grave human rights abuses, such as genocide and forced labor.

Closely related is the strategy of divestiture or divestment. Divestiture strategies involve current holdings that are liquidated over time as their eligibility is no longer consistent with the owner’s objectives, such as fossil fuel companies. But divestiture strategies may also involve a much broader universe of securities, when for example, divestiture strategies were applied to apartheid practices in South Africa in the 60s and 70s.  At that time, any company doing business with South Africa was taken off the list of eligible investments.

In general, this investment approach, when applied exclusively and viewed through the prism of equity mutual funds, in particular, has in the past produced an uneven-to-poor financial track record or total return results.

Size of Exclusionary Segment

A sustainable investing approach, reliance on exclusionary practices is today the most pervasive across portfolios managed for the individual as well as institutional investors. By some estimates, negative/exclusionary strategies across the globe are associated with about US$15 trillion in assets under management as of early 2016.  That is up from US$12 trillion, or an increase of 25% relative to 2014[1].  The number is even higher, rising to US$21 trillion, when norms-based screening, or screening of investments against minimum business practices on the basis of international norms, is added in.

Approach to Implementing Exclusionary Strategies Vary

On the surface, the implementation of exclusionary strategies may seem straight forward. Yet the lack of industry-wide conventions on how to execute such a strategy poses some challenges for investors who must make their own decisions on how best to achieve and meet their specific ethical, religious, social or environmental objectives.  For example, tobacco companies might clearly be subject to exclusion, but should this policy also apply to manufacturers and servicers of vending machines.  Even when a decision is made to avoid investing in companies that are engaged in similar activities, such as tobacco or weapons, there is no consensus or consistency around the thresholds that should be used for the exclusion of these companies.  Firms could be excluded when the designated activities represent the company’s primary or significant source of revenues or these could be excluded if any revenues at all are derived from such activities.

Using the prism of mutual funds, the table below (refer to Exhibit 1) illustrates the variations in the application of exclusionary strategies across five fund firms that offer some of the largest sustainable mutual funds.

Comment on Financial Track Record/Performance

Theoretically, investing in funds or portfolios that limit exposure to certain stocks or eliminates them entirely should require some financial sacrifice. This is because portfolios subject to such restrictions are less able to diversify due to the fact that large segments or entire market segments, such as

tobacco or alcohol, are excluded from the investment universe. Also, one or more of these segments of the market may actually experience intervals of outperformance as was recently the case with tobacco company stocks. The same argument holds for portfolios that add social criteria to the traditional risk-return based financial analysis. Moreover, firms with high ethical standards may incur additional costs in the process of doing so, thereby potentially lowering the performance of their common stocks. Consequently, portfolios with higher ethical screens should exhibit lower performance.

Indeed, past performance of equity oriented mutual funds that have relied largely or entirely on exclusionary strategies have produced an uneven-to-poor financial track record or total return results. At the same time, there have been empirical studies showing that the performance of funds that employ ethical or social considerations is close to that of their equity fund counterparts that don’t employ such considerations. Fewer studies have extended this analysis to fixed income.

This being the case, investors adopting exclusionary strategies should be aware of this still continuing debate and be prepared to potentially accept lower total returns over time.

[1] Source:  2016 Global Sustainable Investment Review, Global Sustainable Investment Alliance