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How to invest

Exclusionary indexing: A transparent, enduring approach to ESG investing

9 minute read
  •  
October 13, 2022
How to invest
Understanding investment types
Article
Page
ESGs
Index funds
Managing portfolios

Key points

  • Investors are increasingly turning to passively managed products to meet their environmental, social, and governance (ESG) investing preferences.
  • ESG index products vary widely in their complexity and approach.
  • Exclusionary index funds may be a suitable option for investors seeking passively managed portfolio building blocks that can avoid exposure to certain business activities that conflict with their ESG preferences.

As interest in sustainable investing grows, more investors are turning to passively managed products to meet their ESG investing preferences. According to Morningstar, net flows to ESG index funds have outpaced net flows to ESG active funds in each of the last five years. In a fund category once dominated by active management, index products now make up nearly half of all ESG fund assets.

ESG indexing is on the rise

Note: Includes U.S.-domiciled ESG funds only.

Sources: Vanguard and Morningstar, as of December 31, 2021.

The growth of ESG indexing mirrors the growth of indexing within the broader fund industry, but with one notable difference. Whereas the broader industry trend has seen most assets flow to traditional market-cap-weighted products, the ESG indexing trend has seen assets dispersed across products that use a wide variety of approaches for incorporating ESG criteria. The proliferation of methodologies has left many investors confused about how to assess and select an appropriate product. This is why Vanguard believes in developing products that transparently allow investors across the globe to reduce ESG risks.

Why Vanguard believes in ESG exclusionary indexing

An exclusionary approach to ESG indexing offers a contrast to the confusion that investors may face in the ESG investment marketplace. By avoiding or reducing exposure to certain business activities while seeking to achieve a market-like return, we believe exclusionary ESG products can help meet the basic investment needs and preferences of a broad subset of ESG-oriented investors. Here’s why:

 

Exclusionary funds are transparent

The first step for any investment plan is to create clear and appropriate financial goals. When a product’s objective and strategy are clear, it’s easier for investors to identify the role it plays in helping them reach those goals.

Vanguard’s exclusionary ESG funds track benchmarks that are derived from common market-capitalization-weighted indexes. Our benchmark providers then apply transparent screening criteria to avoid or reduce exposure to certain industries that many investors are concerned about, such as firearms, tobacco, or fossil fuels.

While our exclusionary funds’ benchmarks apply clearly defined ESG screens, the approach builds in a level of flexibility. Some investors, for example, may wish to maintain exposure to companies with diverse business lines even though alcohol sales account for a relatively small amount of their revenue. These investors may not want to risk the potentially negative impact on diversification and returns that could result from excluding such firms.

To account for these nuances, our funds’ benchmarks use a revenue-based screening methodology that groups companies involved in certain business activities according to three levels of restrictiveness. Within each level, the indexes exclude companies that exceed certain revenue thresholds. The thresholds vary based on whether the involvement is primary or secondary to their business. Within the most restrictive category, for instance, the threshold is 0% for both primary and secondary involvement.1

 

 

A revenue-based exclusions model

Notes: The graphic depicts the screening methodologies used by FTSE (for our ESG equity index funds) and Bloomberg MSCI (for our ESG fixed income index fund). Please refer to the endnotes or prospectuses for additional details on screening methodologies.

An exclusionary approach captures the core benefits of indexing

Exclusionary funds offer many of the advantages of conventional index funds, including broad exposure to a market or market segment, which enables them to serve as building blocks in a broadly diversified portfolio.

Like conventional index funds, exclusionary ESG funds hold securities in proportion to their market-capitalization weighting. Weighting securities by market capitalization harnesses the collective wisdom of market participants on the relative value of securities. It also helps keep portfolio turnover low, since market-weighted funds generally don’t need to buy or sell securities except when a firm is added to or removed from the benchmark.

Exclusionary screening can significantly affect certain sector and industry exposures. However, because screened indexes are broadly diversified and market-cap weighted, the impact on overall benchmark composition and long-term returns is generally minor. Even so, investors must be prepared to expect periods of underperformance. Examples of such periods appear in the chart below, which compares the returns of the FTSE US All Cap Choice Index, the benchmark for Vanguard ESG U.S. Stock ETF, to those of its non-ESG “parent” benchmark.

Exclusionary indexes can be close substitutes for their non-ESG “parent” benchmarks

Monthly returns of FTSE US All Cap Choice Index and its non-ESG “parent” index (2016–2021)

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Notes: The FTSE USA All Cap Index is a market-capitalization-weighted index that measures the performance of U.S. large-, mid-, and small-cap stocks. The FTSE US All Cap Choice Index measures the performance of the FTSE USA All Cap Index after it is screened for certain ESG criteria by the index sponsor, which is independent of Vanguard.

Sources: Vanguard and Morningstar, as of December 31, 2021. 

ESG exclusions continue to stand the test of time

The merits of exclusionary ESG screening are widely recognized, and the approach is employed across ESG product types. As of March 2022, 75% of ESG index funds and 69% of ESG active funds used exclusionary screens in some form to narrow down the universe of securities eligible for inclusion in their portfolios.3 The broad use of exclusionary screening suggests an industrywide understanding that investors in ESG funds would like to avoid certain businesses and industries, irrespective of an ESG fund’s overall strategy or approach.

Exclusionary screens are used across ESG product types

Percentage of ESG funds that employ exclusionary screens

Note: Includes U.S.-domiciled ESG funds only.

Sources: Vanguard and Morningstar, as of March 31, 2022.

For more than 20 years, Vanguard’s exclusionary products have helped investors tap into the power of indexing to meet their ESG investing goals. We continue to work with leading index providers, such as FTSE and Bloomberg MSCI, to help ensure our exclusionary index funds continue to serve as effective portfolio building blocks.

Exclusionary index products have seen consistent growth in recent years

Note: Includes U.S.-domiciled ESG funds only.

Sources: Vanguard and Morningstar, as of December 31, 2021.

Vanguard is an investor-owned company4 with a responsibility to offer products based on their investment merit and potential benefit to investors. With ESG investing, that means developing products that aim to maximize the chances of investment success while thoughtfully considering the preferences and desired outcomes of ESG-oriented investors.

While the ESG investment landscape is sure to evolve, we believe exclusionary index funds will continue to provide compelling benefits to investors seeking a transparent and enduring approach to sustainable investing.

Vanguard’s ESG funds

Note: From left to right, the benchmarks for the exclusionary index products are: FTSE US All Cap Choice Index, FTSE Global All Cap ex US Choice Index, Bloomberg MSCI US Corporate SRI Select Index, and FTSE4Good US Select Index.

Want to see what your ESG options are? Check out our full list of ESG funds to see what might work for your portfolio.

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1 Primary business involvement includes production and manufacturing; secondary business involvement includes retailing and supplying. For cannabis, companies are screened for primary involvement only for equity indexes and not screened at all within fixed income indexes because of data limitations with the index providers. The cannabis screen for our equity products is defined by Industry Classification Benchmark (ICB). For fossil fuels, companies will be screened based on revenue-based thresholds for some activities and ICB classification for others.

2 Our fixed income ESG indexes use a 10% aggregate revenue tolerance across all secondary involvement for both alcohol and adult entertainment categories (e.g., if a company earns 7% of its revenue as an alcohol retailer and 3% as a supplier, the aggregate 10% revenue would result in the company being excluded from the index). This nuance exists because of data limitations of the index providers.

3 Vanguard and Morningstar, as of March 31, 2022.

4 Vanguard is investor-owned, meaning the fund shareholders own the funds, which in turn own Vanguard.

For more information about Vanguard funds, visit vanguard.com or call 800-662-2739 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

ESG funds are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the index provider for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other funds screened for ESG criteria. The index provider’s assessment of a company, based on the company’s level of involvement in a particular industry or the index provider’s own ESG criteria, may differ from that of other funds or of the advisor’s or an investor’s assessment of such company. As a result, the companies deemed eligible by the index provider may not reflect the beliefs and values of any particular investor and may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the screens will depend on the index provider’s proper identification and analysis of ESG data. The advisor may not be successful in assessing and identifying companies that have or will have a positive impact or support a given position. In some circumstances, companies could ultimately have a negative impact, or no impact.

The FTSE4Good US Select Index, FTSE Global All Cap ex US Choice Index, and FTSE US All Cap Choice Index exclude the stocks of companies that FTSE determines engage in, have a specified level of involvement in, and/or derive threshold amounts of revenue from one or more of the following activities: (i) produce adult entertainment; own/operate adult entertainment establishments; distribute adult entertainment materials; (ii) manufacture alcoholic beverages; supply alcohol-related products/services to alcoholic beverage manufacturers; involved in distribution and/or retail sale of alcoholic beverages; (iii) manufacture tobacco products; supply tobacco-related products/services; involved in distribution and/or retail sale of tobacco products; (iv) engage in cannabis cultivation, cannabis distribution, the processing and distribution of cannabis plants, and the creation of cannabis derivative products per the Industry Classification Benchmark (ICB) standards; (v) own and/or operate a gambling establishment; manufacture specialized equipment used exclusively for gambling; provide supporting products/services to gambling operations; (vi) produce chemical or biological weapons and their components; (vii) produce (or produce specific and critical parts or services for) cluster munitions; (viii) produce (or produce specific and critical parts or services for) anti-personnel mines; (ix) produce nuclear weapons or their components; (x) manufacture military weapons systems and/or integral, tailor-made components of these weapons; provide tailor-made products and/or services that support military weapons; provide non-weapons-related tailor-made products and/or services related to the military or defense industry; (xi) produce and sell assault weapons or small arms to civilian customers; produce and sell key components of small arms; involved in the retail and/or distribution of assault weapons or small arms; (xii) involved in the operation and supply of nuclear power generation, that harnesses the energy present within atomic nuclei or their components; engaged in the development, processing, production, and distribution of equipment and facilities that are specifically designed for and critical to the generation of nuclear power; (xiii) own proved or probable reserves in coal, oil, or gas; (xiv) any company that FTSE determines per the ICB standards: (a) engages in the exploration for and drilling, production, and supply of crude oil on land or in offshore areas; (b) primarily engages in the refining and marketing of petroleum products; (c) supplies equipment and services to oil fields and offshore platforms; (d) operates pipelines carrying oil, gas, or other forms of fuel; (e) engages in all three fields of petroleum production: extraction (upstream), transportation (midstream), and refining 6 and marketing (downstream); or (f) mines, processes, and markets coal per the ICB standards; and (xv) generate electricity from oil and/or gas, or thermal coal. The level or type of involvement in, or amount of revenue earned from, certain activities or business segments that lead to exclusion by FTSE can vary from one activity or business segment to another. The Index methodology also excludes the stocks of companies that, as FTSE determines based on its internal assessment, do not meet certain labor, human rights, environmental, and anti-corruption standards as defined by the United Nations Global Compact Principles, as well as companies that fail to meet two of the following three diversity criteria: (1) at least one woman on the board; (2) diversity policies in place; and (3) diversity management systems in place. FTSE uses internal methodologies to analyze various factors in determining whether a company meets the foregoing criteria and/or falls within a particular industry, including whether the company has a certain amount of revenue derived from an industry, the company’s level of involvement in an industry, and the severity of certain controversies (as determined by FTSE), which can vary from one company to another and from one activity to another.

The Bloomberg MSCI US Corporate SRI Select Index excludes the bonds of companies that the Index sponsor determines engage in (which may include manufacturing, owning, and operating), have a specified level of involvement in, and/or derive threshold amounts of revenue from one or more of the following activities: (i) production, distribution, and retail of adult entertainment materials; (ii) production, distribution, retail, and supply of alcohol-related products; (iii) involvement in certain gambling-related business activities; (iv) production, distribution, retail, supply, and licensing of tobacco-related products; (v) manufacture of nuclear weapons or key nuclear weapons components; (vi) manufacture of biological and chemical weapons or key biological and chemical weapons components; cluster munitions whole weapons systems, components, or delivery platforms; landmines whole systems or components; or involvement in the production of depleted uranium (DU) weapons, ammunition, and armor; (vii) production of conventional weapons and components or involvement with conventional weapons support systems and services; (viii) production and/or distribution (wholesale or retail) of firearms or small arms ammunition intended for civilian use (companies that cater to the military, government, and law enforcement markets are not included in the foregoing); (ix) ownership or operation of nuclear power plants or active uranium mines; involvement in uranium enrichment and processing; involvement in the design and engineering of nuclear power reactors; or supplying nuclear power activities; and (x) have an industry tie to fossil fuels (thermal coal, oil, and gas), in particular, reserve ownership, related revenues, and power generation (companies providing evidence of owning metallurgical coal reserves are not included in the foregoing). The level or type of involvement in, or amount of revenue earned from, certain activities or business segments that lead to exclusion by the Index sponsor can vary from one activity or business segment to another. In addition, the Index methodology excludes the bonds of companies that, as determined by the Index sponsor, do not meet certain standards defined by the Index sponsor with respect to an ESG controversies assessment or do not have an ESG controversy assessment score. The ESG controversies assessment measures a company’s involvement in major ESG controversies and how well they adhere to international norms and principles. The Index also excludes bonds of companies that fail to have at least one woman on their board of directors and companies for which the Index sponsor does not have board diversity data. The screens for ESG criteria described above do not apply to government-issued bonds (e.g., U.S. Treasury securities), asset-backed securities, mortgage-backed securities, and commercial mortgage-backed securities, nor do they apply to bonds issued by companies that are not researched by the Index sponsor.