Exclusions

What Is Exclusionary Screening?

Exclusionary screening is a sustainable investing strategy that involves deliberately avoiding investments in companies, industries, or countries that do not align with an investor's ethical, social, or environmental values. This approach, part of the broader category of Sustainable Investing, acts as a "negative screen," filtering out entities involved in activities deemed undesirable or harmful. It is a key method within Socially Responsible Investing (SRI) and Environmental, Social, and Governance (ESG) frameworks, allowing investors to align their Investment Portfolio with personal or institutional principles.

Exclusionary screening has been a foundational element of ethical investment practices for centuries, evolving from religiously motivated divestments to comprehensive modern frameworks.

History and Origin

The origins of exclusionary screening can be traced back centuries, primarily rooted in religious principles. As early as the 18th century, groups like the Quakers prohibited members from participating in the slave trade, while the Methodists, led by John Wesley, advocated avoiding industries harmful to workers or society, such as those involved in alcohol, gambling, or hazardous chemicals.⁴², ⁴³, ⁴⁴, ⁴⁵

In the modern era, exclusionary screening gained significant prominence during the 1960s and 1970s, fueled by socio-political movements. For instance, activists during the Vietnam War era pressured universities to divest from defense contractors.³⁹, ⁴⁰, ⁴¹ A seminal moment for this strategy was the anti-apartheid movement in the 1980s, where widespread divestment from companies doing business in South Africa served as a powerful form of international pressure against the regime.³⁷, ³⁸ A New York Times article from 1986 highlighted the ongoing debate and impact of these divestment campaigns.

More recently, the establishment of organizations like the United Nations Principles for Responsible Investment (UN PRI) in 2006 has further standardized and promoted the incorporation of ESG factors, including exclusions, into mainstream investment decision-making.³², ³³, ³⁴, ³⁵, ³⁶

Key Takeaways

• Exclusionary screening is an investment strategy that avoids specific companies or industries based on ethical or sustainability criteria.
• Common exclusions include "sin stocks" (e.g., tobacco, alcohol, gambling, weapons) and companies with poor environmental or human rights records.
• This approach enables investors to align their investments with personal values and contribute to broader social or environmental goals.
• Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), are increasingly focusing on how funds apply and disclose their exclusionary criteria to combat "greenwashing."
• While promoting ethical investing, exclusionary screening can potentially limit Portfolio Diversification and may not always guarantee superior Financial Performance.

Formula and Calculation

Exclusionary screening does not involve a specific mathematical formula in the way that quantitative financial metrics do. Instead, its "calculation" is qualitative and involves a systematic process of elimination based on predefined criteria.

The process typically follows these steps:

1. Define Exclusion Criteria: Investors or fund managers establish clear guidelines for what activities, industries, or companies will be excluded. These might be based on international norms (like the UN Global Compact), specific revenue thresholds from certain activities, or a company's involvement in controversies.
2. Screen Investment Universe: The entire universe of potential investments is then filtered against these criteria. This often involves analyzing companies' business operations, revenue streams, and reported ESG performance data.
3. Create an Excluded List: Any company that violates the established criteria is placed on an exclusion list and removed from the eligible Investment Portfolio.

While there isn't a formula, quantitative tools can be used to implement the screening, such as:

• Identifying companies that derive more than a certain percentage of revenue from a particular undesirable activity.
• Screening for companies with specific ESG risk ratings below a defined threshold.

For example, a fund might exclude companies with more than 1% of revenue from thermal coal or 10% from oil production.³⁰, ³¹

Interpreting Exclusionary Screening

Interpreting exclusionary screening involves understanding the motivations behind the exclusions and their potential implications for an Investment Portfolio. When a fund or an individual investor applies exclusionary screening, it signals a commitment to avoiding direct financial support for industries or practices deemed harmful or unethical. This can range from traditional "sin stocks" like tobacco and alcohol to controversial weapons, fossil fuels, or companies with poor human rights records.²⁶, ²⁷, ²⁸, ²⁹

The primary interpretation is that the investor prioritizes alignment with their values over potentially broader investment opportunities. For instance, excluding fossil fuel companies means the investor will not benefit directly from their Financial Performance, but also avoids exposure to associated Market Volatility or regulatory risks tied to climate change. The specific criteria used in exclusionary screening are crucial for understanding the ethical stance of the investment.

Hypothetical Example

Consider an investor, Sarah, who wants to build a Sustainable Investing portfolio. She decides to use exclusionary screening as her primary strategy.

Her exclusion criteria are:

• Companies involved in the production or distribution of tobacco.
• Companies that derive more than 5% of their revenue from thermal coal.
• Companies with documented severe human rights violations in their supply chain.

Sarah begins reviewing various mutual funds and exchange-traded funds (ETFs). She looks at a hypothetical "Global Equity Fund A." Upon examining its holdings, she discovers it includes shares of "Tobacco Corp.," a major tobacco producer. Based on her first exclusion criterion, Sarah immediately removes Global Equity Fund A from her consideration, as it fails her exclusionary screen.

Next, she examines "Energy Giant B." While not a tobacco company, a quick check of its revenue breakdown shows that 10% of its revenue comes from thermal coal extraction. This exceeds her 5% thermal coal threshold, so Energy Giant B is also excluded from her potential investments.

Finally, she researches "Manufacturing Inc." and finds reports of severe labor abuses and human rights violations within its overseas factories. This directly violates her third criterion, leading her to exclude Manufacturing Inc.

Through this process of exclusionary screening, Sarah narrows down her investment universe to only those companies that align with her ethical standards, allowing her to build an Investment Portfolio that reflects her values.

Practical Applications

Exclusionary screening is a widely applied technique across various facets of finance and investing:

• Retail Investing: Individual investors often choose mutual funds or ETFs that explicitly state their exclusion policies, allowing them to align their personal values with their investments. Many "ethical funds" or "faith-based funds" utilize exclusionary screening.
• Institutional Investing: Large institutional investors, such as pension funds, university endowments, and foundations, frequently employ exclusionary screening as part of their Fiduciary Duty and to meet the ethical mandates of their stakeholders.²⁵ They may exclude entire sectors (e.g., controversial weapons manufacturers) or companies with poor Corporate Governance records.²⁴
• Fund Management: Asset managers design and manage "screened" funds that adhere to specific exclusionary criteria. These funds are then marketed to investors seeking a particular Ethical Investing profile. The U.S. Securities and Exchange Commission (SEC) has implemented rules to ensure that funds' names accurately reflect their ESG investment strategies, including the use of exclusions, to prevent "greenwashing." For example, the SEC's "Names Rule" requires funds to hold at least 80% of their investments in assets consistent with their name, impacting how ESG funds are labeled and how exclusions are applied.²¹, ²², ²³
• Government and Sovereign Wealth Funds: Some governments and sovereign wealth funds use exclusions based on international treaties (e.g., banning investments in cluster munitions) or national values. Countries can also be excluded if they are subject to sanctions by international authorities.²⁰

Limitations and Criticisms

While exclusionary screening serves as a fundamental tool for Ethical Investing and value alignment, it faces several limitations and criticisms:

• Limited Diversification: By explicitly removing certain sectors or companies, exclusionary screening can limit the available investment universe, potentially leading to reduced Portfolio Diversification. This narrowed scope might lead to higher idiosyncratic risk.¹⁸, ¹⁹
• Potential Impact on Returns: Critics argue that excluding profitable sectors or companies could lead to Financial Performance that underperforms a broader Benchmark or unscreened portfolios. However, research on this impact is mixed, with some studies suggesting no significant negative effect, or even outperformance in some sustainable strategies.¹⁵, ¹⁶, ¹⁷
• Subjectivity of Criteria: What constitutes "harmful" or "unethical" can be subjective and vary significantly among investors. For example, the definition of "fossil fuel exposure" can be complex, involving different types of coal or oil.¹³, ¹⁴ This subjectivity can lead to inconsistencies in how exclusionary screens are applied.
• Lack of Engagement: Exclusionary screening is often passive; it removes an investment but doesn't actively encourage companies to change their behavior. Some argue that active Shareholder Value engagement, where investors retain ownership and use their influence to push for improvements, can be more impactful than simply divesting.¹¹, ¹²
• "Blunt Tool": The approach can be seen as a "blunt tool"¹⁰ because it doesn't differentiate between companies that are actively trying to improve their ESG practices and those that are not. A company might be excluded based on its industry, even if it has leading sustainability initiatives.

Exclusionary Screening vs. Positive Screening

Exclusionary screening and positive screening are two distinct yet often complementary approaches within Sustainable Investing. Both aim to incorporate ESG factors into investment decisions, but they do so from opposite directions.

While exclusionary screening focuses on avoiding negative outcomes, Positive Screening seeks to identify and invest in companies that demonstrate leadership in environmental, social, and Corporate Governance areas. An investor might use exclusionary screening to create a baseline of acceptable investments, and then apply positive screening to select the best-in-class companies from that narrowed pool, creating a more holistic sustainable Asset Allocation.

FAQs

What types of companies are typically excluded in exclusionary screening?

Commonly excluded companies or industries often include those involved in tobacco, alcohol, gambling, adult entertainment, controversial weapons, and fossil fuels. Additionally, companies with poor records on human rights, labor practices, or environmental pollution may be excluded.⁶, ⁷, ⁸, ⁹

Does exclusionary screening affect investment returns?

The impact of exclusionary screening on investment returns is a subject of ongoing debate. While some argue that limiting the investment universe could hinder Financial Performance, others suggest that avoiding companies with high ESG risks can lead to more stable long-term returns. It's important for investors to consider their Risk Management approach and diversification goals.

Is exclusionary screening the same as ESG investing?

No, exclusionary screening is one strategy within ESG investing, but they are not the same. ESG investing is a broad approach that integrates environmental, social, and Corporate Governance factors into investment analysis. Other ESG strategies include positive screening, impact investing, and ESG integration, where ESG factors are considered alongside traditional financial metrics.

How do regulators view exclusionary screening?

Regulators, such as the U.S. Securities and Exchange Commission (SEC), are increasingly scrutinizing how investment funds use ESG terminology, including the use of exclusions, in their names and marketing. Their aim is to ensure transparency and prevent "greenwashing," requiring funds to disclose their methodologies and ensure their portfolio aligns with their stated exclusionary criteria.¹, ², ³, ⁴, ⁵