Investment insights

ESG investing through exclusionary indexing

September 15, 2022

As interest in environmental, social, and governance (ESG) investing has grown in recent years, many investors have turned to index funds that avoid or limit exposure to certain business activities such as firearms, tobacco, or fossil fuels. This type of investment strategy is called exclusionary indexing.

According to Morningstar, net flows to ESG index funds outpaced those to ESG active funds in each of the five years ended December 31, 2021. In a fund category once dominated by active management, index funds now make up nearly half of all ESG fund assets.

Vanguard believes exclusionary ESG index products can help meet the basic investment needs and preferences of a broad subset of ESG-oriented investors.

Defining eligibility for investment

Vanguard’s exclusionary ESG index funds track benchmarks that are derived from conventional market-capitalization-weighted indexes. Our benchmark providers use transparent, clearly defined criteria to systematically exclude companies whose activities conflict with predetermined ESG screening criteria.

Some flexibility is built into our ESG index funds’ benchmarks through revenue-based exclusion models, which allow companies that derive a relatively small amount of revenue from otherwise restricted activities to still be included in an ESG index. Adding a revenue-based exclusion model reduces the risk of being less diversified while also limiting investors’ exposure to those activities.

A revenue-based exclusionary model
From a starting index universe of 100 companies, the revenue-based model narrows the exclusionary product benchmark to 74 companies. Fifteen are excluded because they generate any revenue from producing, supplying, or retailing fossil fuels, firearms, or military weapons, or because they generate any revenue from producing tobacco, cannabis, or conventional military weapons. Five others are excluded because they generate more than 5% of revenue from supplying or retailing tobacco or conventional military weapons, or because they generate more than 5% of revenue from producing adult entertainment, alcohol, or gambling. Six more companies are excluded because they generate more than 10% of revenue from supplying or retailing adult entertainment, alcohol, or gambling.

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.

Keeping the core benefits of indexing

Exclusionary ESG funds offer many of the advantages of conventional index funds, including broad exposure to a market or market segment.

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 rebalance their holdings except when a firm is added to or removed from the benchmark.

In sum, exclusionary index funds may be a suitable option for investors seeking passively managed portfolio building blocks that align with their ESG preferences.

To learn more, read Exclusionary Indexing: A Transparent, Enduring Approach to ESG Investing.

Our exclusionary ESG funds

In the United States, we currently offer four exclusionary ESG index products across equities and fixed income. Each product tracks an index that uses transparent exclusionary measures to remove certain companies from the investment universe based on predetermined ESG screening criteria:

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. (Source: FTSE.)

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. (Sources: Bloomberg and MSCI.)

Notes:

For more information about Vanguard funds and ETFs, visit vanguard.com 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. 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 or bonds 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.

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