Scientific Beta

It is often argued that an investor who is dissatisfied with a company’s ESG behaviour, and who wishes to remedy the situation, should stay on as a shareholder and engage with it. The reasoning is that when an investor divests, their influence over the company ceases. Moreover, the act of divesting is often presented as a passive approach that has no bearing on the company’s management, a capitulation rather than a form of action. We contend that both divestment and engagement are actions that promote change.

We contend that both divestment and engagement are actions that promote change. Divestment is a force of change when it directly and indirectly contributes to raising the cost of capital for divested companies: this limits their ability to invest in projects the investor deems harmful and gives their management an incentive to improve their ESG performance. Properly managed and executed engagement can also contribute to improvement in the ESG performance of investee companies. The empirical results of academic studies indicate that both engagement and divestment approaches can be effective in achieving the desired ESG outcomes. We also argue that these two strategies are entirely compatible: the rise of collaborative engagement campaigns, in which current and potential shareholders combine their forces, is testimony to the fact that divestment does not put an end to an investor’s possibility to engage with a company. Divestment and engagement are hence not mutually exclusive. And a shareholder who engages with a company without signalling a willingness to draw a red line – by exit in case engagement fails – will enter the negotiation in a weak position: the possibility of divestment is in that sense a prerequisite for effective engagement. Conversely, engagement can make divestment campaigns more effective: noisy exits can be more impactful than silent ones. Therefore, far from being mutually exclusive, both engagement and divestment are mutually reinforcing.

Those who deem ESG divesting strategies as incompatible with engagement sometimes see ESG mixing strategies – so-called ESG integration strategies whereby ESG data and analysis are mixed with traditional financial inputs in the portfolio construction process – as a good match with ESG engagement. However, contrary to common perception, ESG mixing strategies – such as over/underweighting based on ESG scores or using portfolio-average ESG scores as a constraint or objective in an optimiser – also lead to divesting based on ESG scores. This is apparent in the two practical examples of investment processes that mix ESG data with traditional factors (value, profitability etc.), which we study. But divestments based on such ESG mixing strategies are arguably less effective than those that result from straightforward filtering of the worst ESG performers; indeed:

ESG reweighting – i.e. partial divestment as opposed to full divestment – dilutes the impact of divestment over a larger number of stocks and leads to divesting from companies with better ESG performances than filtering does.
ESG optimisation based on portfolio-average ESG scores sends muddled and unpredictable signals to companies, which renders divestment (and engagement) less effective.

In contrast to ESG mixing strategies, straightforward ESG filtering, i.e. removing the worst ESG performers from the investable universe, concentrates divestment on the ESG laggards. It sends unambiguous and predictable – and therefore actionable – signals to all companies. In combination with ESG engagement, in particular through collaborative ESG campaigns, we argue that ESG filtering sets the ground for an effective ESG investing policy.