ESG Integration and Exclusion Explained

Two prominent ESG strategies can help investors align their portfolios with their values.

Sustainable investment objectives, whether to benefit the planet, help people or improve corporate processes, are increasingly becoming part of many investors’ priorities. Two of the most common approaches to environmental, social and governance (ESG) investing currently being used are exclusion and ESG integration.

Exclusion and ESG Integration Defined

Exclusion and ESG integration represent very different approaches to sustainable investing. Traditionally, investors mainly used exclusionary strategies for sustainable investing. However, the strategies have been transitioning to ESG integration in recent years.

Exclusion

Exclusionary strategies avoid companies involved in controversial business lines such as tobacco, fossil fuels or for-profit prisons. They also may exclude companies that violate international norms related to human rights, consumer safety and corruption.

This approach may be a good fit if you want your portfolio to conform to a specific belief system, such as religious values, or simply are not comfortable helping to finance certain types of businesses.

Many investors use an exclusionary approach as an initial step when they first implement sustainable investment strategies into their portfolio.

ESG Integration

An ESG integration approach uses insights into ESG-related risks and opportunities alongside conventional fundamental or quantitative analysis. Integration strategies often seek to identify companies that are at the forefront of managing environmental, social and corporate governance issues.

This approach requires a reliable way to incorporate ESG data alongside traditional business and financial analysis. Improvements in ESG data over the past decade have helped investors more effectively combine financial and risk-management goals with the sustainability issues that matter to them.

ESG integration is intended to select companies tackling ESG issues head-on and to invest in companies that offer potential risk and performance benefits. For example, rather than using exclusion to avoid all companies in fossil fuel industries, an investor may opt to invest in companies that are leaders among their peers and have adopted a clear plan to reduce greenhouse gas emissions across their value chain. Likewise, an investor may be able to invest in companies that promote diversity, equity and inclusion, focus on the health and well-being of their employees or are especially proactive about data privacy.

In some cases, investors pursue their sustainable investing goals using a thoughtful combination of exclusion, ESG integration and conventional investment strategies. A hybrid approach may be helpful for families whose members have different values or disagree on how much those values should influence investment decisions.

Effect on Investment Performance

When Northern Trust Wealth Management evaluates sustainable investing strategies, we subject them to the same rigorous due diligence we apply to all investment strategies on our platform, and we perform additional diligence to ensure that the strategies live up to their stated ESG goals.

As you consider whether and how to employ different sustainable investing approaches, talk with your financial advisor about the options available and trade-offs they may involve. For example, excluding a particular kind of company may make your portfolio more consistent with your values, but it also might introduce other risk factors. It is important to understand how your ESG-based investment choices might affect your portfolio’s overall risk and return profile to select the best strategies that align with your financial goals and meet your sustainable investing objectives.