Responsible investing screens are powerful tools for investors, allowing them to build portfolios of companies that are consistent with their principles.
However, many investors can become distracted by the notion that there are two types of screens: positive screens and negative screens.
In reality they’re just two sides of the same coin: The resulting portfolio is identical, regardless of whether the screen is perceived to be excluding “bad” companies or including “good” ones. Rather than focusing on positive and negative screens, investors should focus on whether the securities being selected reflect their principles and financial objectives.
The ubiquity of investment screens
Screens are a familiar and well-known investment tool, and they extend far beyond the world of responsible investing. As a matter of fact, every investment portfolio is the result of a screen, including only those companies that meet the investor’s criteria and excluding those that don’t. For example, in Ben Graham’s classic book from 1949, The Intelligent Investor, he provides rules on the selection of stocks, including capital structure, dividend payments, and earnings multiples—all of which have been translated into numerous value-investing screens over the decades.
Let’s consider Graham’s recommendation of a “long record of continuous dividend payments.” Whether one views this in terms of which stocks to avoid (those with a short or nonexistent record) or which to pursue (those with a long track record), the resulting outcome should be a portfolio that includes only companies that have been paying a dividend for some minimum period of time.
The salient issue when determining which securities to hold isn’t whether this is an example of employing a “negative” screen or a “positive” one. Rather, the more important issue is what qualifies as a “long record.” An investor who views this to be 50 years is likely to end up with a rather different portfolio than one who thinks it’s seven years. Some investors may also have specific requirements about the level and growth of the dividend, further distinguishing their screening criteria and portfolio results.
What distinguishes responsible investing screens?
Screens based on ESG criteria operate in the same manner. These responsible investing screens simply divide the investment universe into acceptable and unacceptable portions based on certain environmental, social, or governance criteria. What distinguishes one screen from another is the metric and the threshold of acceptability. For example, one could use a metric based on total carbon emissions or based on carbon emissions normalized by sales. One could use a threshold that permits investment in companies only if normalized emissions are below a certain level or only if they’re better than peer average.
These responsible investing screen characteristics, as well as whether the screen is applied selectively or without exception, create the differences in outcomes. Active managers typically exercise discretion when forming the final portfolio, using the screen criteria as just one input into their decision. Index-based investors typically follow a rules-based approach and wouldn’t selectively override the criteria.
The bottom line
ESG screens are a powerful and frequently used tool for responsible investors. They allow investors to identify companies that best reflect their objectives. There’s no need to be distracted by trying to determine whether securities are being chosen using a “negative” screen or a “positive” one.
Instead it’s more valuable to focus on the metric and threshold that define the screen and ensure that investors’ specific principles are represented. These are the choices that will meaningfully impact which securities remain eligible for investment; accordingly, they're much more important than whether a screen is perceived as removing “bad” companies or including “good” ones.
With additional contributions from Gwen Le Berre, Director of Responsible Investing.
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