Lifting the veil on RI screening

In addition, RI rating criteria often involve a degree of subjectivity, especially in the absence of credible public company data, leading investors to rely on voluntary disclosure or, in some cases, forced disclosure through shareholder activism.

To make matters more complex, RI inclusionary criteria often conflict: the same company might have a passing grade in some of its activities and a failing grade in others, often resulting in subjective ratings or outright exclusion from certain indices.

“There are many different screening criteria that analysts can apply, so it really depends on the RI strategy [a fund is] seeking to adhere to,” says Jeffrey Chan, a responsible investment analyst with CI Investments Inc. in Toronto.

Furthermore, he says, “there exist many different approaches to implementing RI, from ESG integration to shareholder engagement to thematic investing. Depending on the strategy that a firm chooses to implement, their approach will be different.

“No single strategy is necessarily best,” Chan continues. “It really just depends on the mandate of the fund and what the manager is trying to achieve.”

Dustyn Lanz, CEO of the Responsible Investment Association, adds, “ESG strategies vary according to the mandate of the index.” For example, he says, “an index might have a mandate to invest in ESG leaders, in which case the index would be composed of companies with high ESG scores relative to their industry peers.” Indices with a social responsibility mandle, on the other hand, may simply exclude “sin” stocks, such as tobacco and weapons.

The pillars that form the basis for ESG investing are typically aligned to the 17 United Nations (UN) sustainable development goals (SDG), says Tony Mahabir, chair and CEO of Toronto-based Canfin Financial Group and president of the Convention of Independent Financial Advisors (CIFA), an organization with consultative status to the Economic and Social Council of the UN. CIFA members are focused on adhering to the UN’s SDG objectives.

Using the SDGs as reference, index providers have developed a variety of core, customized and thematic indices, which include companies based on how well they adopt each of the themes.

For example, New York-based MSCI Inc. has several ESG indices, ranging from its broad-based core MSCI ESG Leaders indices to a range of customized indices in areas such climate change and low-carbon leaders. This index issuer gives an overall company ESG rating, using a seven-point scale from “AAA” to “CCC,” and provides scores and percentiles indicating how well a company manages each key ESG issue relative to industry peers.

In a similar vein, FTSE Russell of New York ranks companies based on 14 SDG themes, using some 300 indicators to measure the quality of each company’s management with respect to each theme and the relevance of each theme to the company. FTSE Russell applies an average of 125 indicators to each company.

In Canada, the Jantzi Social Index, overseen by Toronto-based Sustainalytics, is a market capitalization-weighted index that comprises 50 companies on the TSX composite index. The Jantzi index uses two exclusionary criteria — product involvement (military contracting, nuclear power and tobacco) and major negative ESG impact (corporate controversies and incidents such discrimination lawsuits and oil spills) — to select companies for inclusion.

The methodologies for selecting companies vary.

Screening criteria can be positive or negative. Lanz explains that negative screening “refers to the systematic exclusion of certain industries or sectors based on ESG or ethical concerns.” Tobacco and weapons are common negative screens, but funds can exclude other industries that investors may wish to avoid, such as fossil fuels, gambling, terrorism affiliations, and human rights and labour violations.

You can also use the Morningstar Sustainability Rating for Funds to help you select investments that align clients’ return expectations with their values, Mahabir says. Morningstar rates more than 20,000 mutual funds and ETFs worldwide, using a five-globe rating system, where five is the best rating. Each company in the portfolio is graded on a scale of 0 to 100 relative to other firms in its global industry peer group. While the RI indices provide sustainability rankings to individual companies in which funds may invest to meet their ESG criteria, Morningstar provides a sustainability ranking to the full spectrum of mutual funds.

Digging into screens

Positive screening refers to a “best in class” approach, in which securities are selected based on strong ESG scores relative to their industry peers, Lanz says. “It’s common for a fund to combine negative and positive screening to exclude the laggards and include the leaders,” he says.

In certain instances, your clients might question why a company that is engaged in a so-called “dirty industry” is included in an RI fund. “[The company] may also be engaged in initiatives that would merit its inclusion in an RI fund,” Chan says, “such as a commitment to reducing carbon emissions or executive compensation linked to ESG performance.

“Maintaining a position in these companies may be a more impactful way to enact change than simply divesting,” he adds. “As a shareholder, you have the ability to engage with company management and to help drive improvements in performance. With divestment, you relinquish any ability to do so.”

Lanz agrees: “Shareholder engagement can be an act of responsible ownership that can be a powerful way to change corporate behaviour,” he says. “Engagement refers to the use of shareholder power to influence a company’s performance on ESG issues, using specific tactics such as dialogue with senior management, proxy voting and shareholder proposals aimed at improving a company’s ESG performance.”