Institutional investors need a greater understanding and education of exclusion lists due to varied and numerous ramifications, according to a new paper by Hermes Investment Management, the £28.6 billion manager focused on delivering superior, sustainable, risk adjusted returns to its clients – responsibly.
The report from the firm’s Global Equities team, From faith to fact in ESG exclusions: a behind-the-scenes analysis, models four different approaches to excluding holdings with climate change concerns, while ostensibly meeting the same goal: to produce diverse risk and performance outcomes. The modelsfound that:
- Excluding any one of the typical sin-stock categories has historically had little impact on overall portfolio performance
- Even if an industry or sector scores low on ESG measures (for example, tobacco), it can still outperform – investors banking on sustainable returns from exclusion lists may have to adopt a longer-term view
- Combining exclusion lists has historically shown a smoother risk/return profile than those focused on single factors, although investors need to keep watch on correlations among excluded companies
- Exiting entire industries – such as energy – can have a very significant impact on performance and risk exposures
Lewis Grant, Senior Portfolio Manager, said: “The exclusion of certain businesses from investment portfolios was initially practiced by a fervent few as one of the earliest forms of responsible investing. Now, we’re seeing the movement gain a much broader audience, and while they may seem simple in principle, the reality can be much more complex. Tolerance levels must be set to govern exposures to companies directly involved in one or more screened-out lines of business, as well as those forming related supply chains.”
Among the findings, the report’s models found that some exclusion lists can also introduce style bias into a portfolio. For an exclusion list incorporating a range of historically excluded sin stocks, the metrics indicate a shift towards a value bias, while excluding the energy sector reveals a style drift towards higher growth names.
Grant concluded: “Our analysis has shown that applying exclusion lists will affect investment portfolios in a number of ways depending on the scope, concentration and idiosyncratic features of the screen in question. It is crucial that investors undertake detailed research to manage the risks involved in negative screening. That said, the potential for varied outcomes should not deter investors from embarking on the process.”