12 Jun 2020 5 min read

Divestment damages: quantifying the impact of ESG exclusions

By Silvio Corgiat Mecio

The perils of ESG exclusions are often exaggerated – but so are their benefits.



The market is making progress in the incorporation of environmental, social and governance (ESG) information into investments. In Europe, ESG funds saw inflows of €30 billion in the first quarter of the year, even as European funds overall suffered outflows of almost €150 billion.

Fast as this growth has been, it has been limited by a line of reasoning that is, in our view, unjustified:

1. Responsible investment requires excluding large parts of the investment universe.
2. Exclusions will have a negative impact on performance;
3. Responsible investment will have a negative impact on performance.

We have discussed elsewhere the variety of approaches to responsible investment beyond exclusions (including ‘ESG-tilted’ mainstream funds as well as more specialised strategies like thematic and impact investment). Importantly, through stewardship, investors can use their influence to raise standards at investee companies regardless of what fund they use. And there is a growing body of evidence showing the financial resilience of ESG funds – including during the recent market turmoil.

So, Points 1 and 3 above are not supported by the facts. What about Point 2? Must blanket exclusions translate into a loss of return?

Not necessarily. As an illustration, we have examined the impact of excluding the energy sector from a widely used global equity index and found it to be minimal over the period under consideration.

Source: MSCI, LGIM. Past performance is not a guide to future performance.

Annualised over five, 10 and 15 years, the returns and volatility of the two indices are almost identical. There is even a slight outperformance of the ex-energy index[1]:

Source: MSCI, LGIM. Based on historical monthly data between January 2005 and December 2019. Past performance is not a guide to future performance.

Of course, it should not be assumed that the lessons from excluding one sector translate across other sectors, and much will depend on the diversification and investment horizon of the starting portfolio.

To be clear, the point of this analysis is not to recommend energy divestment; the world will continue to rely on oil and gas products, from the fuels that enable our home deliveries through to the plastic in our gadgets and even to hand sanitiser.

Rather, our aim is to help dispel the myth that responsible investment means embarking on an all-excluding journey towards underperformance.

Carrots and sticks

Having established that exclusions do not necessarily have a negative financial impact, it is worth examining whether they have a positive ESG impact. Indeed, some worry that selling runs the risk of placing a stock in the hands of less scrupulous investors.

In response to this, we would emphasise first that divestment must be a credible threat to drive change. Saying to companies ‘stop or I’ll ask you to stop again!’ limits the effectiveness of the engagement that investors have with companies. As a recent review of the academic literature put it, ‘divestment reinforces engagement – it does not preclude it’. Under LGIM’s Climate Impact Pledge, we have seen companies that we had initially removed from certain funds – not because they were operating in a ‘bad’ sector, but because they were not keeping up with their peers – make sufficient improvements to be reinstated.

Second, the options available to investors are not binary. Between owning 0% and 100% of a stock lies a spectrum which active funds and ‘ESG-tilted’ index funds can leverage by investing in companies in proportion to their ESG profile, using capital allocation to reward improving companies and penalise laggards.  

We believe this approach can enhance the ESG profile of a portfolio. The table below illustrates the difference between excluding all companies owning fossil fuel reserves, and a tilted index which prioritises the most ‘carbon-efficient’ companies.

Source: MSCI, Trucost, LGIM, as at 31 January 2020. Past performance is not a guide to future performance.

A significant reduction in fossil fuel exposure is thus possible without committing to blanket exclusions which may have unintended consequences of their own. Our recent survey found this approach resonates with pension savers, a majority of whom preferred their pensions to be invested by default less in low-scoring ESG companies, with divestment reserved only as a tool of last resort.

So let us stop talking about exclusions as necessarily leading to financial ruin. Better yet, let us stop talking about what must be excluded; we can focus instead on what must be scaled up – and how.

Without new government policies, for example, institutional asset owners that prefer proven technologies and developed markets may remain reluctant – and sometimes even legally unable – to invest in less liquid assets in emerging markets that might face political and currency risk. Simplistic solutions – sell fossil fuels, buy renewables! – do not do justice to the complexities of decarbonising the global economy, in our view.

The good news is the pool of capital is not fixed, and the response to the coronavirus has shown that resources and ingenuity can be found. As calls strengthen for a green, sustainable recovery, let us learn from the crisis to build resilience into portfolios.

For more detail on how we approach responsible investing at LGIM, see the chapter on integration in our latest Active Ownership report.


[1] Our analysis illustrates long-term dynamics and pre-dates the coronavirus and oil price crashes from earlier this year.


Key Risks
Past performance is not a guide to the future. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.

Views expressed are of Legal & General Investment Management Limited as at 12 June 2020.  Forward-looking statements are, by their nature, subject to significant risks and uncertainties and are based on internal forecasts and assumptions and should not be relied upon.  There is no guarantee that any forecasts made will come to pass.  Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision.

Silvio Corgiat Mecio

Senior Quantitative Strategist

Silvio works in the Solutions Group and looks after the design and implementation of bespoke investment and risk-management strategies. Silvio leads LGIM’s ESG modelling framework: this covers internal ESG scoring and the integration of ESG themes into the index portfolio construction process. Prior to joining LGIM, Silvio worked in derivatives valuation roles for major financial institutions in Italy, Ireland and UK. He graduated with honours from the University of Turin with an MSc in Finance. He is a certified FRM and a CFA charterholder.

Silvio Corgiat Mecio