Ethical and ESG Investing in Australia: Screens, Trade-Offs, and What the Labels Mean

This article explains what ESG and ethical investing involve, how different screening approaches work, what typically gets excluded under common screens, and the trade-offs that come with applying values-based constraints to a portfolio. It also covers why these constraints are relevant to an Investment Policy Statement (IPS).

What ESG and Ethical Investing Mean#

ESG refers to three categories of non-financial factors used to assess companies:

• Environmental: carbon emissions, resource use, waste management, climate risk exposure
• Social: labour practices, supply chain standards, community impact, data privacy
• Governance: board composition, executive pay, transparency, shareholder rights

ESG analysis uses these factors as inputs alongside traditional financial metrics. It does not inherently mean excluding any industry. A fossil fuel company with strong governance practices and transparent emissions reporting might score well on certain ESG frameworks.

Ethical investing is a broader, older term. It typically involves value-based judgments about which industries or activities are acceptable. An investor who excludes tobacco companies on moral grounds is making an ethical investment decision. The criteria are personal rather than standardised.

The two concepts overlap but are not identical. ESG is a framework for analysis. Ethical investing is a framework for inclusion or exclusion based on values. Many products combine both.

Screening Approaches#

There are several distinct methods for incorporating ESG or ethical considerations into a portfolio. Each produces a different result.

Negative Screening (Exclusions)#

Negative screening removes companies or entire industries from the investable universe. Common exclusions include fossil fuels, gambling, tobacco, weapons manufacturing, and controversial practices such as animal testing or labour rights violations.

This is the simplest and most common approach. Many Australian ethical ETFs and superannuation options use negative screens as their primary methodology.^¹

Positive Screening#

Positive screening selects companies that demonstrate strong ESG characteristics, rather than simply removing the worst performers. A positively screened fund might favour companies with low carbon intensity, strong workplace diversity, or robust governance structures.

Best-in-Class#

Best-in-class screening selects the highest-rated ESG performers within each sector, rather than excluding entire sectors. Under this approach, a portfolio might still hold energy companies, but only those with the strongest environmental practices relative to their peers.

This method preserves sector diversification while tilting toward better ESG performance within each industry.

ESG Integration#

ESG integration incorporates environmental, social, and governance factors into the broader investment analysis process without necessarily excluding any company or sector. Fund managers consider ESG risks and opportunities alongside financial fundamentals when making investment decisions.

This is the least restrictive approach. It does not guarantee that any specific industry is absent from the portfolio.

Impact Investing#

Impact investing targets measurable social or environmental outcomes alongside financial returns. Examples include investments in affordable housing, renewable energy infrastructure, or social enterprises. Impact investments are typically assessed against specific outcome metrics, not just ESG scores.^²

This approach is more common in private markets and specialised funds than in broad market ETFs.

How Ethical Screens Work in Australian Products#

In Australia, ethical and ESG screens appear most commonly in exchange-traded funds (ETFs) and superannuation fund options.

Several ASX-listed ETFs apply ethical screens to broad market indices. The methodology is typically documented in the fund's Product Disclosure Statement (PDS) and index methodology guide. These documents specify which industries are excluded, what thresholds trigger exclusion (for example, a company deriving more than 10% of revenue from fossil fuels), and how the remaining companies are weighted.

Major superannuation funds increasingly offer "sustainable," "responsible," or "ethical" investment options alongside their default options. These options apply varying combinations of negative screening, positive screening, and ESG integration. The specific methodology differs between funds.

The Illuminvest IPS builder asks whether an investor wants to exclude certain industries or activities, with options including fossil fuels, gambling, tobacco, weapons, or no exclusions. These map directly to negative screening, the most straightforward approach to implement in a portfolio.

What Gets Excluded Under Common Screens#

The most frequently excluded categories in Australian ethical products are:

Fossil fuels. Companies involved in the extraction, processing, or significant use of coal, oil, and gas. Thresholds vary: some screens exclude any involvement, others exclude only companies above a revenue threshold.

Gambling. Operators of casinos, betting platforms, and gaming machines, as well as companies deriving significant revenue from gambling-related services.

Tobacco. Manufacturers of tobacco products and, in some screens, companies involved in distribution or retail of tobacco.

Weapons. Manufacturers of controversial weapons (cluster munitions, landmines, nuclear weapons) and, in broader screens, conventional weapons manufacturers and defence contractors.

Other exclusions that appear in some products include alcohol, adult entertainment, nuclear energy, genetically modified organisms, and companies with significant human rights controversies.

The specific thresholds and definitions vary between products. Two funds labelled "ethical" may define fossil fuel involvement differently, leading to different portfolio compositions. Reading the methodology, rather than relying on the label alone, is the only way to understand what a product actually excludes.

Trade-Offs of Ethical Screening#

Applying any screen to an investment universe changes the portfolio's characteristics. These changes involve genuine trade-offs.

Tracking Error#

A screened portfolio will deviate from broad market indices like the ASX 200 or MSCI World. Excluding entire sectors means the portfolio's returns will differ from the benchmark, sometimes favourably, sometimes not. This deviation is called tracking error.

For investors who measure performance against a broad index, tracking error is a cost. For investors whose primary goal is values alignment, it is an expected consequence.

Sector Concentration#

Removing sectors narrows the portfolio. In Australia, where the market is already concentrated in financials and resources, excluding fossil fuels removes a significant portion of the ASX.^³ The remaining portfolio may be more heavily weighted toward sectors like technology, healthcare, or consumer staples.

This concentration changes the portfolio's risk profile. It does not necessarily increase or decrease risk, but it changes the nature of the risk.

Fee Differences#

Ethical and ESG products sometimes carry slightly higher management fees than their unscreened equivalents, reflecting the additional research and methodology involved. The difference is often small (perhaps 0.05% to 0.20%), but over long time horizons, even small fee differences compound.^⁴

Some screened products have fees comparable to standard index funds. The fee difference is narrowing as competition in the space increases.

The Performance Debate#

Whether ethical or ESG screening improves or harms investment returns is one of the most frequently asked questions in this space. The honest answer is that the evidence is mixed.

A meta-analysis of over 2,000 empirical studies found that the majority showed a non-negative relationship between ESG factors and corporate financial performance.^⁵ Some studies find modest outperformance for ESG-screened portfolios. Others find modest underperformance. Many find no statistically significant difference.

Performance depends heavily on the time period, the specific screen applied, and the market conditions. Excluding fossil fuels, for example, would have helped performance during periods when energy stocks underperformed and hurt performance during energy price spikes. There is something honest about acknowledging that values-based investing does not come with a guaranteed financial bonus or penalty.

The most defensible conclusion is that ethical screening changes what is in the portfolio and therefore changes the return pattern, without reliably making it better or worse over long periods.

RIAA Certification#

The Responsible Investment Association Australasia (RIAA) is the industry body for responsible investing in Australia and New Zealand. RIAA offers a certification program for financial products that meet its responsible investment standard.

Certification involves an independent assessment of a product's responsible investment processes, including its screening methodology, ESG integration practices, and reporting.^⁶ Products that pass receive the RIAA Certified Responsible Investment label.

RIAA certification does not guarantee returns or endorse a specific ethical standard. It verifies that a product's methodology is consistent with its stated responsible investment claims. For investors evaluating ethical products, RIAA certification provides a baseline level of assurance that the label reflects a genuine process.

Greenwashing and Label Inconsistency#

"Greenwashing" refers to the practice of marketing a product as environmentally or socially responsible when the underlying methodology does not substantiate that claim. In investing, this can take several forms:

• Funds labelled "sustainable" that exclude only a narrow set of companies while holding others with significant ESG concerns
• Marketing materials that emphasise values alignment while the actual portfolio closely resembles an unscreened index
• ESG scores from different providers that disagree substantially on the same company

ASIC has taken an active interest in greenwashing in financial products, issuing guidance and enforcement actions against misleading sustainability claims.^⁷ The regulatory environment is evolving, but the burden still falls partly on investors to read product documentation rather than relying on marketing labels.

Different ESG rating providers often assign different scores to the same company, because they weight factors differently and use different data sources. A company rated highly by one provider may rate poorly with another. This inconsistency is a structural feature of the ESG landscape, not a temporary problem.

The practical implication is that the methodology section of a PDS or index guide is more informative than the product name. A fund called "Ethical Leaders" tells an investor less than the document explaining exactly which companies are excluded and why.

Why Ethical Constraints Belong in an IPS#

An Investment Policy Statement documents the rules and parameters that govern a portfolio. Ethical constraints are a legitimate component of an IPS because they define the boundaries within which the portfolio operates.

Including ethical screens in an IPS serves a practical function beyond values expression. Investors who hold assets they find objectionable may experience what behavioural finance research describes as "regret risk." If a tobacco company in a portfolio generates strong returns, the investor benefits financially but may feel uncomfortable. If it generates losses, the discomfort compounds. Most people find it easier to stay the course with a portfolio that does not conflict with their convictions.

Documenting these constraints in advance also prevents ad hoc, emotionally driven decisions. Rather than selling a position in reaction to a news story, the IPS establishes clear criteria from the outset.

Summary#

ESG investing uses environmental, social, and governance factors to evaluate companies, while ethical investing applies values-based exclusions or preferences. Screening approaches range from negative screening (excluding industries) to impact investing (targeting measurable outcomes), each producing different portfolio characteristics. The performance evidence is mixed, with ethical screens neither consistently helping nor harming returns over long periods. Reading a product's actual methodology matters more than its label, as greenwashing and inconsistent ESG ratings mean that similar-sounding products can hold very different portfolios.

Sources#

1. Responsible Investment Association Australasia. (2024). Responsible Investment Benchmark Report 2024 Australia. https://responsibleinvestment.org/resources/benchmark-report/

1. Global Impact Investing Network. (2023). What you need to know about impact investing. https://thegiin.org/impact-investing/need-to-know/

1. ASX. (2024). S&P/ASX 200 sector breakdown. https://www2.asx.com.au/markets/market-resources/asx-index-methodology

1. Morningstar. (2024). Sustainable funds fee study. https://www.morningstar.com.au/insights/funds/sustainable-fund-fees

1. Friede, G., Busch, T., & Bassen, A. (2015). ESG and financial performance: Aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, 5(4), 210-233. https://doi.org/10.1080/20430795.2015.1118917

1. Responsible Investment Association Australasia. (2024). RIAA Certification Program. https://responsibleinvestment.org/certification/

1. ASIC. (2024). How to avoid greenwashing when offering or promoting sustainability-related products (Information Sheet 271). https://asic.gov.au/regulatory-resources/financial-services/how-to-avoid-greenwashing-when-offering-or-promoting-sustainability-related-products/