Positive Screening

Positive Screening: Renewable Energy Leaders

Positive screening—also called best-in-class screening or thematic investing—takes the opposite approach from exclusion. Rather than removing companies, it actively selects companies demonstrating strong performance in specific areas: environmental stewardship, social responsibility, governance quality, or specific mission alignment with themes like clean energy, sustainable agriculture, or water infrastructure.

Where negative screening is defined by what it leaves out, positive screening is defined by what it seeks. Both approaches alter the portfolio's composition relative to a market-cap-weighted index, but the resulting portfolios look very different and serve different investor motivations.

BEST-IN-CLASS SCREENING

Best-in-class screening selects the companies that score highest on ESG metrics within each industry—including industries that would be entirely excluded by strict negative screens. A best-in-class screen might include an oil company that ranks first among its peers on environmental management, waste reduction, carbon reporting, and governance practices—even though the company's core business is extracting fossil fuels.

The argument for best-in-class over strict exclusion: rather than removing entire industries, channeling capital toward the better-performing companies within each industry creates an incentive for companies to improve their practices to attract ESG-oriented investment. The oil company competing to rank highest on environmental practices among its peers is incentivized to improve those practices in ways that a simple exclusion policy doesn't create.

The argument against: retaining any oil company in an environmentally focused portfolio undermines the portfolio's coherence. A best-in-class screen that includes "the least bad" actor in a problematic industry has lower intuitive appeal for investors whose primary motivation is values alignment rather than incentive creation.

Most broad ESG index funds—including Vanguard ESG U.S. Stock ETF (ESGV) and iShares ESG MSCI USA ETF (ESGU)—use some combination of negative screening and best-in-class selection, rather than pure versions of either.

THEMATIC ESG: THE CLEAN ENERGY EXAMPLE

Thematic investing concentrates the portfolio in specific sectors or themes believed to benefit from structural trends. Clean energy is the most prominent ESG theme, encompassing solar and wind power generation, energy storage, electric vehicles, energy efficiency technology, and the infrastructure supporting the energy transition.

Major clean energy thematic funds:

Invesco Solar ETF (TAN): Concentrated in solar energy companies—manufacturers, project developers, and technology suppliers. As of 2024, approximately 50 holdings.

iShares Global Clean Energy ETF (ICLN): Broader clean energy exposure—wind, solar, hydroelectric, geothermal, and related technology companies. Approximately 100 holdings globally.

First Trust Global Wind Energy ETF (FAN): Concentrated in wind energy specifically—turbine manufacturers, component suppliers, and wind farm operators.

ALPS Clean Energy ETF (ACES): U.S. and Canada-focused clean energy—solar, wind, hydroelectric, geothermal, bioenergy, and related technology.

iShares MSCI Global Clean Energy Producers ETF (ICEP): Specifically targets companies generating electricity from clean sources rather than manufacturers and technology providers.

These funds differ in critical ways: sector concentration, geographic exposure, what counts as "clean energy," and whether they include nuclear power (a carbon-free but politically contested energy source that some clean energy funds include and others exclude).

THE PERFORMANCE RECORD OF CLEAN ENERGY THEMATIC FUNDS

Clean energy thematic funds experienced one of the most dramatic boom-and-bust cycles in recent investment history. From early 2020 to February 2021, the S&P Global Clean Energy Index rose approximately 230%. From the February 2021 peak through 2023, it declined approximately 60%, dramatically underperforming the broad market.

The causes of the decline: rising interest rates (which disproportionately affect capital-intensive, long-duration renewable energy projects), supply chain disruptions, high valuations reached at the peak, and challenges with specific companies facing operational problems. Clean energy stocks are highly interest-rate sensitive because projects are typically financed with debt, and higher discount rates reduce the present value of long-duration income streams.

This performance history illustrates the fundamental risk of thematic investing: concentration in a specific sector or theme produces volatility that far exceeds a diversified portfolio, and the timing of that volatility relative to the investor's need for capital determines whether thematic exposure is rewarding or damaging.

An investor who allocated 5% to ICLN in 2018, held through the 2021 peak and the subsequent decline, and still holds in 2024 has experienced something like what a patient long-term investor would experience in any volatile asset—potential for eventual recovery but significant interim drawdowns. An investor who entered at the 2021 peak after the theme gained significant media attention has experienced a very different outcome.

THE QUALITY OF ESG DATA: A STRUCTURAL PROBLEM

Both negative and positive screening rely on ESG ratings and data from research providers. The major ESG data providers—MSCI, Sustainalytics, FTSE Russell, and S&P Global—each apply different methodologies for measuring environmental, social, and governance performance. The result: the same company can receive dramatically different ESG scores from different providers.

A 2019 paper by Berg, Koelbel, and Rigobon (MIT Sloan) found that ESG ratings from six major providers had an average correlation of approximately 0.54—substantially lower than the correlation between credit ratings from major agencies (which exceeds 0.90). For the same company, one provider might assign a top quartile ESG rating while another assigns a bottom quartile rating.

The implications for positive screening:

"ESG funds" that rely on different rating providers hold very different portfolios, even if they share the same label. Two funds both marketed as "sustainable" may hold mutually exclusive sets of companies based on their rating methodologies.

The "best-in-class" selection depends heavily on which rater's methodology defines best-in-class. A company that is best-in-class by MSCI's scoring may rank poorly by Sustainalytics' methodology.

Investors who choose a positive-screening fund based on the fund's stated values alignment should look at the actual holdings list, not the marketing description. The fund's actual top holdings often reveal more about its real investment thesis than its name or description.

IMPACT MEASUREMENT: THE MISSING LAYER

A defining characteristic of most positive-screening funds is the absence of quantified impact measurement. The fund selects companies with high ESG scores, but it doesn't measure whether those companies actually produce better environmental or social outcomes than alternatives.

The question that impact measurement would address: does holding companies with top MSCI ESG ratings produce more renewable energy, less pollution, or better labor practices than holding the market index? The answer is not self-evidently yes—ESG ratings measure corporate processes and disclosures more than they measure actual outcomes.

This gap between rating (which describes company practice) and impact (which describes real-world effect) is the central intellectual criticism of both positive and negative ESG screening as practiced in mainstream funds. It is addressed more directly by the community investing and impact measurement approaches covered in subsequent articles—where capital is explicitly deployed to projects with measurable social or environmental effects.

SECTOR CONCENTRATION AND DIVERSIFICATION

Thematic clean energy funds create sector concentration risk that broad ESG funds do not. A 60-holding clean energy fund concentrated in solar and wind has dramatically lower diversification than a 300-holding ESG-screened broad market fund.

For investors who want clean energy exposure without the associated concentration risk, a hybrid approach—a small allocation (5% to 10% of the equity portfolio) to a clean energy thematic fund, held alongside a broad market or broad ESG fund—provides the thematic exposure while limiting the impact of any single theme's underperformance on the overall portfolio.

A 5% allocation to a clean energy fund that drops 60% produces a 3% drag on the overall portfolio—meaningful but not devastating. The same exposure representing 50% of the portfolio at 2021 prices produces a 30% portfolio-level decline—a very different experience.

Thematic concentration should be sized relative to the investor's ability to maintain the position through a severe drawdown without being forced to sell. The emotional ability to hold through a 60% decline in a thematic position requires honest self-assessment before the investment is made, not during the decline.