Negative screening involves the exclusion of certain holdings from the investment universe based on ethical or ESG criteria or factors.
The screening decision is based on the consideration that capital should not be made available to certain sectors or companies that damage the environment or act against social or ethical principles. The basis of such a decision may be normative, ethical or moral – or combination thereof. Common negative screens exclude investments in tobacco, alcohol and weapons manufacturers, recently with the additions of fossil fuel based industries due to concerns over climate change. Other negative screens aim to exclude companies that are considered poor executors in the areas of environmental and social management or corporate governance.
Negative screening can be applied to almost all asset classes, including listed equities, corporate bonds, government bonds and private equity.
When applied to equities and bonds, negative screening has the potential drawback of reducing efficient portfolio diversification, with potentially adverse consequences for total returns. This may be particularly relevant in the South African context given the relatively small size of the JSE, its domination by a small number of large cap stocks, and its sector concentration. In addition, the longer the list of exclusion criteria, the more difficult – if not impossible – it is for the portfolio manager to match a benchmark.
However research by Credit Suisse indicates that over the longer term, exclusion strategies need not compromise diversification and relative risk-adjusted returns. The caveat is that the shorter term can lead to significant deviation from such longer-term results, both positively and negatively. This could prove a material issue for the providers of ESG investment products if their performance is judged on a shorter-term time horizon. Quantitative strategies to mitigate such volatilities may assume a key significance.
Case study – Exclusionary screening by Norway’s Government Pension Fund Global
In 1996, Norway’s Government Pension Fund Global was the world’s smallest sovereign wealth fund. By 2011 it had become the biggest and by 2017 it exceeded USD1tn. Owning shares in over 9,000 companies in 73 countries, Norway aims to fund the welfare of future generations. The fund wishes to share in the lasting economic success of its companies. Sustainable development can make companies more robust and can underpin long-term returns; the fund therefore aims to mitigate the environmental and social impacts of its holdings. It aspires to set high standards of governance and to engage actively with companies. Norway does not invest in businesses that directly or indirectly contribute to killing, torture, deprivation of freedom, or conflictbased violations of human rights. Investment is allowed in some defense companies as only certain types of weapons (e.g. nuclear) are banned. Norway is regarded as the most responsible sovereign wealth fund in the world.