ESG portfolio screening

Environmental, Social, and Corporate Governance (ESG) criteria is a term that is often used synonymously with, or at least similarly to, sustainable investing, socially responsible investing, mission-related investing, or screening. This article is primarily concerned with ESG portfolio screening, since this is the most popular form of ESG investing. Screening is also the most practical and accessible ESG strategy for individual investors with limited resources available. For example, an investor could switch their stocks from a total market indexing approach to investing in exchange-traded funds (ETFs) following ESG indices. Although green bonds exist, this article focuses on equities. ESG-themed ETFs represent only 1.5% of ETF assets under management in Canada, but the number of available products doubled in 2020.

ESG considerations are of a non-financial nature. For example, environmental issues include climate change, pollution, water issues, etc. Social topics include human rights, child labor, health and safety, corruption, etc. Governance issues include executive compensation, board independence, diversity, etc. There is a growing demand for ESG funds and ETFs. Investors interested by ESG investment options want to align their personal values and financial goals. According a survey quoted by Vanguard, 87% of US Millennials desire sustainable investments.

This article addresses four main topics: (1) ESG ratings, on which screenings approaches are often based; (2) how ESG portfolio screening works; (3) how screening influences the risk and return characteristics of the resulting portfolios; and (4) is this strategy effective in demonstrably influencing corporate behaviour, i.e. can it really "change the world". The article concludes with alternative ideas on how to affect environmental or social change. The literature on ESG investing and related topics is vast and this article can only summarize a very small portion of it.

ESG data and ratings
ESG scores or ratings are numbers, often from zero to 100, assigned to publically traded companies by rating services, such as MSCI, Bloomberg, Thomson Reuters, KLD or Sustainalytics; there were 125 such organizations in 2016. The scores are based on ESG data, which is reported by corporations largely on a voluntary non-standardized basis. Each rating service gathers information from different sources, then uses proprietary methods to convert the ESG data into scores. Different rating agencies weight the three pillars of ESG differently. For companies that don’t report ESG data, a score might be estimated based on statistical models.

Given all of these differences, it is not surprising that the same company can obtain a very different score from different ESG ratings providers: "companies with a high score from one rater often receive a middling or low score from another rater". Therefore, correlations between different providers are weak for the overall ESG score. Correlations between raters are even worse for the individual E, S and G pillars, being as low as 0.2 for governance.

According to Berg et al. (2020), this heterogeneity in ESG ratings has three major consequences:
 * "First, ESG performance is less likely to be reflected in corporate stock and bond prices, as investors face a challenge when trying to identify outperformers and laggards. Investor tastes can influence asset prices (…), but only when a large enough fraction of the market holds and implements a uniform nonfinancial preference. Therefore, even if a large fraction of investors have a preference for ESG performance, the divergence of the ratings disperses the effect of these preferences on asset prices. Second, the divergence hampers the ambition of companies to improve their ESG performance, because they receive mixed signals from rating agencies about which actions are expected and will be valued by the market. Third, the divergence of ratings poses a challenge for empirical research, as using one rater versus another may alter a study’s results and conclusions."

What is ESG portfolio screening?
ESG screening involves changing one's portfolio, in particular the equity portion, to take environmental, social, and governance aspects into account. The two basic approaches are exclusionary (negative) and inclusionary (positive) screening. Both types of screening often take ESG scores into account.

Exclusionary screening
Exclusionary (negative) screening involves excluding or underweighting certain companies or industries based on specific criteria. A classic example is that some investors choose to completely exclude weapons, gaming, tobacco or alcohol-related stocks from their portfolios. Or else firms with low ESG scores could be excluded.

Inclusionary screening
Inclusionary (positive) screening is sometimes called the "best-in-class" approach. Firms are compared with industry peers, and those with higher ESG ratings are selected or overweighed. One issue with this approach is that various ESG rating services use different criteria and methods, resulting in potentially "very different security holdings and weightings in inclusionary screening strategies".

Some investors combine positive and negative screening.

Financial characteristics of screened portfolios
Investors are interested by ESG strategies for various non-financial reasons including ethical ones, but typically they also care about financial performance. Will ESG portfolio screening cost them something in the form of lower portfolio returns, higher investment costs, higher volatility, etc.?

Overall assessment
According to Pedersen et al. (2020), "opinions differ dramatically across academics and practitioners about whether ESG will help or hurt their performance".

Friede et al. (2015) present a second-level review about ESG investing and financial performance: a review of review papers. They distinguish studies about individual firms versus those made at the portfolio level. The latter seem more relevant for retail investors who are likely to employ mutual funds or ETFs to implement ESG investing. Of the 155 primary studies about ESG portfolios, 16% find a positive relationship between EGS and financial performance, 11% find a negative relationship, 36% find a neutral relationship, and 27% obtain mixed results. In other words, the evidence is not conclusive either way.

Amon et al. (2019) synthetize the literature as follows:
 * "Several articles have shown that there is no common conclusion drawn on the question, whether doing well and doing good is possible. They have shown that the outcome to this critically depends on the choice of the time period, region, portfolio selected, asset strategy proposed etc."

Risk and return
Despite the lack of consensus about the relationship between ESG screening and financial performance, it is still worth exploring some specific studies on this topic. A recent example is Alessandrini and Jondeau (2020). Their data covers the period 2007-2017. Compared to a broad market index, for specific developed regions (USA, Europe, Pacific), ESG screening only had a small influence on investment returns or standard deviations (volatility), although the authors acknowledge that this may have been affected by ESG investing gaining popularity over that period.

In theory, negative screening (e.g., excluding "sin" stocks) should lower performance since the investible universe is reduced. Another way to phrase this is that "in equilibrium, (…) market segmentation leads to higher expected returns to non-green companies". (See also .) And indeed sin stocks have outperformed according to various empirical studies (e.g., and studies cited in ). However this outperformance of sin stocks might be explained by exposure to specific stock factors (profitability and investment) as opposed to an "exclusion premium".

Sector and factor exposures
Alessandrini and Jondeau (2020) note that ESG screening resulted in different sector exposures, relative to the whole market. Specifically, their ESG portfolios were overweighed information technology stocks and underweight financial and energy stocks. They also note that ESG screening influenced the factor exposures of the portfolios, yielding "an increase in the exposures to large and profitable companies".

Statman (2007) had also noted different sector exposures and different style tilts in a socially responsible index versus the S&P500.

Tracking error
Statman (2007) remarked that a certain socially responsible index outperformed the S&P500 in some periods but underperformed in others, a form of tracking error which might lead an investor to abandon a ESG strategy. He notes that the "best-in-class" approach features less tracking error than negative screening.

Diversification
Another consideration is the reduced diversification of screened versus unrestricted portfolios. Excluding companies from portfolios may lead to higher idiosyncratic risk, especially for intense screening approaches which severely lower the number of companies, both for positive and negative screening. Moderate levels of positive screening however, such as keeping the "best 50%" in each sector, have almost no effect on idiosyncratic risk.

Investment fees
ESG-screened investment products tend to attract higher fees. For example, the following table compares the management expense ratios (MERs) of the cheapest and broadest ("Core") ETFs in the IShares Canada lineup with their ESG or "sustainable" equivalents, as of January 2021.


 * {| class="wikitable" style="text-align:center"

! Asset class !! MER, market ("Core") ETF !! MER, ESG or "sustainable" ETF
 * Canadian equities || 0.06% || 0.23-0.55%
 * US Equities || 0.07-0.1% || 0.28%
 * International equities || 0.22% || 0.34%
 * Emerging market equities || 0.27% || 0.36%
 * Canadian bonds (aggregate) || 0.10% || 0.20%
 * }
 * Emerging market equities || 0.27% || 0.36%
 * Canadian bonds (aggregate) || 0.10% || 0.20%
 * }
 * Canadian bonds (aggregate) || 0.10% || 0.20%
 * }

This means that a simple index portfolio made up of ETFs covering these asset classes will be significantly more expensive for the ESG version. However, ESG-screened asset allocation ETFs are available from both Ishares and BMO and have the same MERs, or are only slightly more expensive, than their unscreened equivalents.

Turnover
One study shows that all forms of screening increase portfolio turnover. Higher turnover will lead to higher implementation costs, and possibly higher taxable capital gains distributions for the investors (in non-registered portfolios).

Summary
In summary, it is not clear at this stage if ESG screening hurts or benefits portfolios, from a risk and return point of view. Diversification is decreased, and turnover increases, but this may be manageable. The foregoing might be considered relatively good news if the greatest consideration of the ESG investor is having social and environmental impact through changes in corporate behaviour. We now look at the evidence about the actual social and environmental impact of ESG screening.

Impact on corporations
ESG investors hope that by screening their equity portfolio using ESG ratings or criteria, they will have an impact on corporations which are included or excluded. The thinking goes that corporations will change their behaviour and that this will positively impact society or the environment. The question is does this actually work, or as the title of a recent review paper asks, "Can sustainable investing save the world?"

There are two main ways in which investors can impact corporations through capital allocation decisions (including ESG screening). The first way is to provide incentives to corporate management to improve their ESG practices, therefore affecting the quality of company activity. According to a literature review from Kolbel et al. (2020) "there is no empirical evidence that explicitly links sustainable investors’ screening approaches to changes in ESG practices". While ESG screening may affect asset prices, there is no evidence that this ultimately results in improved ESG behaviour by corporations.

The second mechanism targets company growth, i.e. the level of company activities, by influencing the financing conditions for these corporations. The aim is to reduce the activity of ‘bad’ companies and help the growth of sustainable ones. This can only work if a company actually needs new external financing, which is often not the case for large established corporations. Divesting existing shares only leads to a change in ownership.

Here is how Meir Statman summarizes negative screening:
 * "Environmental, social, and governance (ESG) investors who do no more than exclude stocks of fossil fuel producers from their portfolios are banner-minded; they want to do well and expect to earn market returns, if not higher. Banner-minded investors might want the expressive and emotional benefits of staying true to their values, but they are unwilling to sacrifice any portion of their utilitarian returns for these benefits. More importantly, they do no good, doing nothing to enhance the utilitarian, expressive, and emotional benefits of others."

Other forms of ESG investing
Three other forms of ESG investing are (i) shareholder engagement, where individual shareholders or groups of shareholders try to directly influence corporate behavior, for example by voting during annual meetings, or having direct discussions with corporations, (ii) ESG integration, where active portfolio managers include ESG information in their investment analysis, among other criteria; (iii) impact investing, which implies making targeted investments "with the dual objective of generating measurable, positive societal and/or environmental impact and a level of financial return".

There is good evidence that shareholder engagement can be effective in changing corporate activity, although this is something that institutional investors can more easily do. Very wealthy individuals could also attempt allocating a portion of their capital to impact investing, knowing that they are likely to earn lower than market returns. Statman calls this "pulling plows", as opposed to waving banners.

More direct ways to change the world
In general, ESG investing attempts to have social or environmental impact through the intermediary of the corporation. This is an indirect and uncertain way to reach this goal. There are much more direct paths, like changing one’s habits to consume fewer resources, giving time or money to a carefully chosen charity, etc.