NIMF 2019: ESG exclusion criteria do not reduce profitability

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Sustainable investing has its basis in a first step via exclusion criteria. Investors still believe that excluding a group of equities is both difficult and costly and has a negative impact on the investment portfolio. 

Various studies have reported over the years that investments in "Sin Stocks", ie, companies linked to activities such as alcohol consumption, tobacco or alcohol production, adult entertainment and gambling, have generated above-average returns in the past (Fabozzi, Ma and Oliphant, Journal of Portfolio Management, Fall 2008).  Can investors still invest in this area if it is known that, according to the World Health Organisation, eight million people die every year from the effects of tobacco consumption, including 890,000 passive smokers? 

Against this background, Storebrand already excluded tobacco companies, arms producers, spirits producers and companies linked to corruption and child labour from all its own funds and portfolios in 2005. But what impact does this have on the portfolio and on returns?

Substitution baskets with similar yield objects

The portfolio team replaces the excluded companies (exclusion basket) with a risk model to identify the basket of replication. Investments are made within the universe (substitution basket), which has yield objectives similar to those of the excluded companies.  The risk model used by Storebrand is developed by MSCI Barra. It characterises each company in terms of factor exposures, for example, sector, industry, currency, market beta, as well as quant-factor exposures such as momentum, value, size and quality.

In the example "exclusion of tobacco companies", the substitution basket consists almost exclusively of large-cap, non-tobacco consumer goods companies. Overall, the factor exposure of the substitution basket should be almost identical to that of the exclusion basket. There is one exception, namely the pure, sector-specific tobacco exposure, which cannot be substituted by non-tobacco companies. However, the risk model easily replaces all other factor exposures, such as currency, market beta and quantum factor exposures, resulting in as low a tracking error as possible compared to the complete, unscreened benchmark.

The advantage of this type of approach in dealing with exclusions can be summarised as follows. The primary objective is to avoid investing in tobacco companies, but to remove them from the benchmark and then reweight the benchmark components to 100% would result in an underweight in low beta, high quality equities. Therefore, it makes sense to eliminate tobacco without being underweight, low beta and high quality, and exactly this is achieved by keeping the excluded stocks in the benchmark and then minimizing the fund's tracking error towards the full benchmark.

Factor exposures adjusted for excess returns

In 2017, the thesis of the excess return of "Sin Stocks" was reviewed again. Frank Fabozzi and his team actually discovered that the total excess return disappears when adjusted for other factor exposures. The conclusion is that the historical excess returns of "Sin Stocks" did not materialise because they were sinful and ethical investors avoided them, leading to a low valuation and high returns for the future. On the contrary, the conclusion was that the excess return is due to an unintended factor burden, and that this could have been achieved by investing in other, factor-like, but "meaningless" stocks. It is precisely this approach that Storebrand has been pursuing since 2005.


Bård Bringedal is chief investment officer, Storebrand Asset Management SA. He will be presenting The Storebrand way of sustainable investments - from index through ESG-optimised to active solutions - including the argument that sustainable investment does not have a negative impact on performance - during this year's edition of the Nordic Investment Managers Forum, which takes place October 16 in Zurich, 17 in Munich and 18 in Luxembourg. InvestmentEurope editorial director  Jonathan Boyd is moderating the series.

For full details about the NIMF speakers from groups including DNB AM, Jyske Capital (Jyske Bank), Storebrand AM and Sparinvest, visit