Best-in-class screening

Suppose a fund only ever buys the companies with the very best ESG scores across the whole market. It might end up owning nothing but software firms and skipping every cement, steel and oil company — because heavy industry, however well run, usually scores lower on environmental measures than a services business.

Best-in-class screening avoids that trap. Instead of ranking every company against every other company, it ranks companies within their own sector and picks the leaders from each one. A cement company is compared with other cement companies, not with a software firm. The result is a portfolio that is still tilted toward good ESG practice, but is spread across industries the way an ordinary diversified fund would be.

Section 18.9.1 places best-in-class screening alongside two other approaches to building a socially responsible investing (SRI) portfolio:

• Negative screening — excluding companies in restricted businesses such as alcohol, tobacco, gambling, weapons or hazardous chemicals.
• Positive screening — rating, scoring and ranking companies on ESG parameters and selecting those above a chosen threshold, market-wide.
• Best-in-class screening — "same as Positive screening except that selection is not [of the] highest rated stocks [market-wide], but [of the] highest rated stocks across various sectors. Hence a diversified portfolio is created."

The workbook also notes that research has shown a strategy of buying high-ESG-quotient stocks and selling low-ESG-quotient stocks produces statistically significant outperformance against the benchmark index, which is the empirical case the chapter gives for why ESG screening of any of the three kinds has gained momentum, including from Indian asset managers now launching ESG funds.

Illustrative figures. An ESG-focused PMS scheme with Rs 10 crore AUM wants exposure across the whole Nifty 50 sector spread, not just technology and financial services.

Under positive screening, the fund ranks all 50 stocks on ESG score and picks the top 15 overall — which turns out to be 11 IT and financial services names and only 4 from manufacturing, energy and cement combined, because those sectors structurally score lower.

Under best-in-class screening, the fund instead ranks stocks within each of the Nifty's 12-odd sectors and picks the top two or three from each. The result: still roughly 15 stocks, but now including the best-run cement company, the best-run oil refiner and the best-run steel maker — each scoring lower in absolute terms than the top IT name, but each the clear ESG leader of its own industry. The Rs 10 crore is now spread across the same broad sector mix an ordinary diversified fund would hold.

Chapter 18, section 18.9.1, lists the three SRI screening approaches together, immediately before the Core and Satellite section. Expect a question that describes a screening method and asks which of the three it is — best-in-class is the one candidates most often confuse with plain positive screening.

• Best-in-class is positive screening done sector-by-sector, not a fourth, unrelated method. The workbook defines it explicitly as positive screening with one change.
• The change is entirely about diversification, not about a different or stricter ESG threshold. A best-in-class portfolio can include a company with a lower absolute ESG score than a rejected company in another sector, as long as it leads its own sector.
• Negative screening excludes; positive and best-in-class screening select. Do not describe best-in-class screening as an exclusion method.
• The statistically significant outperformance finding cited in the chapter is about buying high-ESG and selling low-ESG generally — it supports ESG investing as a category, not best-in-class screening specifically over the other two methods.