Exclusion

What Is Exclusion?

Exclusion, within the realm of responsible investing, refers to the practice of deliberately omitting certain companies, industries, or countries from an investment portfolio based on specific ethical, social, environmental, or governance criteria. This approach is a key strategy for investors who seek to align their portfolio management with their values, beyond traditional financial metrics. Exclusion is often implemented as part of a broader investment policy that defines acceptable and unacceptable investments. It aims to avoid supporting businesses whose activities are deemed harmful or contrary to specific moral or sustainability principles.

History and Origin

The concept of exclusion in investing has roots tracing back centuries, with early examples often tied to religious or moral objections. For instance, religious institutions historically avoided investments in industries like alcohol, tobacco, or gambling. In modern finance, the formalization of exclusion as an investment strategy gained prominence with the rise of Socially Responsible Investing (SRI) movements in the 20th century. A significant push came during the anti-apartheid movement in the 1980s, when many institutional investors, including universities and pension funds, divested from companies operating in South Africa to protest its racial segregation policies. This historical period demonstrated the power of collective investor action and highlighted exclusion as a tool for social and political change. Today, large sovereign wealth funds, such as the Norwegian Government Pension Fund Global, explicitly implement comprehensive ethical guidelines that lead to the exclusion of companies involved in activities like controversial weapons, tobacco, or severe environmental damage.¹²,¹¹,¹⁰ These guidelines, refined over decades, exemplify the mature application of exclusion criteria in global investment.⁹

Key Takeaways

• Exclusion is an investment strategy that removes specific companies or sectors from a portfolio based on non-financial criteria.
• It is a core component of responsible investing, allowing investors to align their capital with personal or institutional values.
• Common grounds for exclusion include involvement in controversial products (e.g., tobacco, weapons), human rights abuses, or severe environmental harm.
• The practice of exclusion can influence corporate behavior by signaling investor disapproval and affecting a company's cost of capital or reputation.
• While primarily values-driven, exclusion can also be seen as a form of risk management against reputational or regulatory risks associated with certain industries.

Interpreting Exclusion

Exclusion is interpreted as a clear statement of an investor's values and ethical boundaries. When an investor, or a fund manager on behalf of clients, implements an exclusion policy, it means they believe the activities of the excluded entities are fundamentally incompatible with their investment objectives or moral compass. For individual investors, it simplifies decision-making by narrowing the universe of investable assets to those that meet defined ethical standards. For institutional investors, exclusion reflects a commitment to fiduciary duty that extends beyond mere financial return to encompass broader societal considerations, consistent with principles like stakeholder capitalism. It guides asset allocation decisions by drawing a clear line, preventing investment in companies that cross certain thresholds of unacceptable behavior or product involvement.

Hypothetical Example

Consider "GreenGrowth Fund," an ethical investing fund committed to environmental stewardship. GreenGrowth has an exclusion policy that forbids investment in companies deriving more than 5% of their revenue from thermal coal mining or oil sands extraction.

When reviewing potential investments, the fund's analysts evaluate "EnergyCo," a large energy conglomerate. EnergyCo reports that 10% of its revenue comes from thermal coal operations. Despite EnergyCo showing strong financial performance in other segments, GreenGrowth Fund's exclusion policy mandates that EnergyCo cannot be included in its portfolio because it exceeds the 5% thermal coal revenue threshold.

Conversely, "WindPower Inc.," a renewable energy company, has no involvement in fossil fuels. WindPower Inc. would be eligible for investment, assuming it meets other financial and ESG criteria. This demonstrates how the exclusion policy acts as a gatekeeper, filtering out investments based on predefined ethical parameters before other analyses are performed.

Practical Applications

Exclusion is widely applied across various sectors of the financial world:

• Retail Investment Products: Many mutual funds, exchange-traded funds (ETFs), and private wealth management services offer "screened" portfolios that explicitly exclude companies involved in alcohol, tobacco, gambling, firearms, or fossil fuels. These cater to individual investors seeking to align their portfolios with personal values.
• Institutional Investments: Large pension funds, endowments, and sovereign wealth funds often adopt comprehensive exclusion lists. The Norwegian Government Pension Fund Global, for example, publishes detailed criteria and lists of companies it excludes based on severe human rights violations, corruption, or environmental damage.⁸ These decisions are informed by an independent Council on Ethics.⁷
• Regulatory Frameworks: Regulators increasingly consider how funds label and manage their ESG-related claims. While the US Securities and Exchange Commission (SEC) has had shifting stances on specific disclosure rules, measures like the "Names Rule" aim to prevent greenwashing by requiring funds to invest at least 80% of their assets in line with their names (e.g., "ESG" or "Sustainable" funds). This indirectly impacts exclusion practices, as funds claiming to exclude certain sectors must genuinely do so and disclose their methodologies.⁶,⁵
• Principles for Responsible Investment (PRI): Organizations like the UN-supported UN Principles for Responsible Investment advocate for the integration of Environmental, Social, and Governance (ESG) factors into investment processes, which includes both positive selection and negative screening (exclusion).⁴,³,²

Limitations and Criticisms

While exclusion is a powerful tool for value alignment, it faces several limitations and criticisms:

• Limited Impact on Corporate Behavior: A common critique is that exclusion alone may not directly alter a company's behavior. If an investor sells shares, another investor with different ethical considerations may simply buy them, leading to no net change in the company's cost of capital or access to funding. Critics argue that shareholder engagement or active ownership (where investors retain shares and use their voting power to influence management) might be more effective in driving corporate change.
• Narrowing the Investment Universe: Implementing strict exclusion criteria can significantly reduce the pool of investable assets, potentially limiting diversification opportunities and, in some cases, affecting expected returns. Investors must balance their ethical objectives with their financial goals.
• Effectiveness Against Greenwashing: The rise of ESG investing has also led to concerns about greenwashing, where funds or companies make misleading claims about their sustainability efforts without genuine commitment. While regulators like the SEC have attempted to address this with disclosure rules, the complexity of defining and verifying "ethical" or "sustainable" activities remains a challenge.¹
• Defining "Bad" Companies: The criteria for exclusion can be subjective and vary widely. What one investor considers unethical (e.g., fast food) another might not. This lack of universal standards can lead to inconsistencies and make direct comparisons between different "ethical" funds difficult.

Exclusion vs. Divestment

While closely related, "exclusion" and "divestment" refer to distinct but often intertwined actions in responsible investing.

Exclusion is a forward-looking investment strategy or policy. It means deciding not to invest in certain assets, companies, or sectors from the outset based on predefined criteria. An investment manager, for instance, might establish an exclusion list that prevents them from buying shares in tobacco companies. This is a proactive screening measure that shapes the eligible universe of investments.

Divestment, on the other hand, is the act of selling off existing assets or holdings. It is a reactive measure taken when an investor already holds an investment that later violates their ethical or policy guidelines, or when a decision is made to cease holding certain types of assets. For example, a university endowment might decide to divest from fossil fuel companies it currently holds, selling those shares in the market. Divestment is often the outcome of an exclusion policy being applied to an existing portfolio or a new policy being adopted that necessitates the sale of previously held investments.

In essence, exclusion sets the boundaries for future investments, while divestment is the action of liquidating current holdings that fall outside those boundaries or are no longer aligned with the investor's evolving values.