Ethical investing approaches: screening and best-in-class

Previous articles asked why ethical investment matters, gave an introduction to Sustainable (environmental, social and governance, or ESG) investing and a short history of ethical investing. In this article, Dr Quintin Rayer outlines how ethical investors use screening and best-in-class approaches to achieve their goals.

Q G Rayer (2019), Ethical investing approaches: screening and best-in-class, The Private Investor, the newsletter of the UK Shareholders’ Association, issue 202, October, p8-10, 18th October 2019.


Previous articles asked why ethical investment matters [1], gave an introduction to Sustainable (environmental, social and governance, or ESG) investing [2] and a short history of ethical investing [3]. This article outlines how ethical investors use screening and best-in-class approaches to achieve their goals.

Ethical investors wish to allocate funds to areas they feel deserve investment selectively and to avoid businesses or activities that do not. Typically, they seek to avoid the so-called ‘sextet of sin’, which generally refers to alcohol, tobacco, gambling, pornography, armaments and nuclear power [4]. Different investors may wish to avoid different or more sectors than these, including areas such as animal testing, the fur trade and child labour. Exclusions or ‘screening’ is only one strategy of several. Investors can ask themselves whether they wish to:

• Avoid unethical companies, but accept investment in ethically neutral companies, which do neither good nor harm? This is known as negative screening.
• Invest only in ethical companies, avoiding both unethical and ethically neutral companies? Called positive screening.
• Actively seek to influence corporate behaviours for the better. Examples would include positive engagement or shareholder activism.

The answers an investor reaches regarding these questions and how they might be implemented leads to a range of investment approaches.

Investment approaches: Screening & Best-in-class

Ethical investors focus on activities that are seen as desirable or else avoiding undesirable outcomes. Sustainability, using ESG factors [2], can provide a helpful framework when it comes to determining whether a business activity should be seen as having a positive or negative impact. Ethical investing means different things to different people, and institutional investors may answer to several stakeholders that differ in the conclusions they have reached between themselves. Despite different approaches available, some investors may feel that none of the primary methods fit their requirements. The focus here is on screening, and ‘best-in-class’, but other approaches include tilting, or influence and engagement. These will be considered in a later article.

Screening

different approaches to screening

Figure: Positive and Negative Screening (reproduced from [5])

Screening appears to be the most usual approach with investments tested against several requirements. These seek to identify companies’ impacts as positive, negative, or ‘ethically-neutral’ (broadly doing neither good nor harm). When considering screening, an investor must decide whether to avoid ethically-neutral companies (see Figure).

• Negative screening avoids companies deemed to be involved in unethical activities but invests in ethically-neutral companies.
• Positive screening only invests in ethically beneficial companies, avoiding both ethically-neutral and unethical companies.

A concern with screening is that it can generate portfolios with company size and sector biases, which could limit portfolio diversification.

Best-in-Class

This approach includes companies and industries that are the best operators within the class considered, including the best companies within a sector. This can mean selecting the ‘least bad’ businesses in some sectors. It can motivate companies in ethically-challenging sectors to improve. Consider a fictitious mining company against some different ethical investing strategies. Suppose the company has a weak record regarding environmental damage during extraction, pollution from refinery waste products, treatment of labour and indigenous peoples displaced or harmed by its activities.

Consider how different ethical selection methods might approach this company:

• Positive screening would exclude the company based on its sector or activities, which would likely be unacceptable. Management can take no action to make the company acceptable (apart, presumably, from winding the company’s operations up), leaving them no motivation to improve.
• Negative screening would similarly exclude the company due to its sector or activities.
• Under best-in-class, the sector’s ‘least bad’ companies can attract investment. By comparing with peers, management can improve their environmental and social record to be amongst the best in their sector and attract investment. In a competitive market environment, companies can be motivated by a ‘race to the top’. This can generate real improvements for those affected by the company’s activities, even if they will never be perfect.

For investors seeking to more actively engage, the best-in-class approach can provide benefits to those most affected by harmful company practices, but can mean a closer involvement with firms that not all will feel comfortable with.

How this helps Investors

By appreciating the approaches used by ethical fund managers when selecting companies, individuals who wish to invest ethically should be better placed to understand the strengths and weaknesses of techniques offered, helping them choose an approach best suited to their needs.

References

[1] Q. G. Rayer, “Introducing Ethical Investing,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 199, pp. 12-13, April 2019.
[2] Q. G. Rayer, “Introducing sustainable “ESG” investing,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 200, pp. 10-11, June 2019.
[3] Q. G. Rayer, “A short history of ethical investing,” The Private Investor, the newsletter of the UK Shareholders’ Association, no. 201, August 2019.
[4] C. Krosinsky, N. Robins and S. Viederman, Evolutions in sustainable investing: strategies, funds and thought leadership, JohnWiley & Sons, 2012.
[5] Q. G. Rayer, “Exploring ethical and sustainable investing,” CISI, The Review of Financial Markets, no. 12, pp. 4-10, 2017.


 

About Dr Quintin Rayer

Quintin is a Chartered Fellow of the Chartered Institute for Securities and Investments, a Chartered Wealth Manager and holds a Physics degree from Imperial College London and a Physics doctorate in atmospheric physics from Oxford University and is a Fellow of the Institute of Physics.