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The Three Letters

Positive Screening: Best-in-Class ESG Approaches

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What Is Best-in-Class ESG Screening and How Does It Work?

Best-in-class ESG screening — also called positive screening or positive tilt — takes a fundamentally different approach to sustainable investing than negative exclusion. Rather than removing entire industries from an investment universe, best-in-class selects the companies with the highest ESG scores or the strongest ESG profiles within each industry sector. The oil company with the best environmental management and governance in its peer group stays in the portfolio; the oil company with the worst ESG profile does not. The portfolio retains full sector diversification while maintaining an ESG quality tilt relative to the broad market.

Quick definition: Positive (best-in-class) screening selects the highest ESG-quality companies within each industry sector for portfolio inclusion, rather than excluding entire sectors. It maintains sector diversification while creating an ESG quality tilt, and typically results in lower tracking error than sector-exclusion approaches.

Key takeaways​

  • Best-in-class screening retains sector exposure by selecting top ESG performers within each sector — accepting that imperfect-sector companies with strong ESG management deserve investment.
  • The approach is based on the theory that capital allocation within sectors — directing it toward better-managed companies — creates incentives for ESG improvement more effectively than wholesale exclusion.
  • Best-in-class portfolios typically have lower tracking error relative to conventional benchmarks than exclusion-based portfolios.
  • The S&P 500 ESG Index uses a variant of best-in-class methodology, excluding the bottom 25% of companies by ESG score within each sector while maintaining broad sector representation.
  • The approach raises the philosophical question of whether holding the "best" fossil-fuel company constitutes a legitimate ESG choice — a question that different investors answer differently.

How Best-in-Class Works​

Best-in-class methodology proceeds through several steps:

Step 1 — Universe definition: The starting universe is typically a broad market index. Companies in absolute exclusion categories (cluster munitions, tobacco, in some frameworks) may be removed first, then best-in-class applied to the remainder.

Step 2 — ESG scoring: Each company is scored using an ESG rating — from MSCI, Sustainalytics, or a proprietary source. The score may be aggregate (single ESG score) or pillar-specific (separate E, S, and G scores).

Step 3 — Sector grouping: Companies are grouped by industry sector — using GICS (Global Industry Classification Standard) sectors or similar.

Step 4 — Within-sector selection: Within each sector, companies are ranked by ESG score. A specified percentage of the top ESG performers are selected (e.g., the top 75% by ESG score in each sector, or the top quartile within each sector).

Step 5 — Portfolio construction: Selected companies are weighted within the portfolio — typically by market capitalization adjusted for ESG score (ESG-tilted weighting).

The S&P 500 ESG Index​

The S&P 500 ESG Index is the most widely tracked US best-in-class ESG product. Its methodology removes:

  • Companies involved in tobacco manufacturing, controversial weapons, and small arms (absolute exclusions)
  • Companies in the bottom 25% of each GICS industry group by S&P DJI ESG score
  • Companies that are involved in controversies at a defined severity level

The result is a portfolio that contains approximately 300 of the S&P 500's 500 companies, weighted by market capitalization, with an aggregate ESG score materially higher than the full index. Sector weights are broadly similar to the full S&P 500 because exclusions are applied within sector groups rather than across the entire index.

The S&P 500 ESG Index attracted controversy in 2022 when Tesla was removed from the index while ExxonMobil remained. The removal reflected Tesla's low overall S&P DJI ESG score (driven by governance and social controversy flags) despite its environmental mission — illustrating the non-obvious outcomes of aggregate ESG scoring and raising questions about what "best-in-class" really means when an EV manufacturer scores below an oil company.

Best-in-class vs. exclusion comparison​

The Philosophy Behind Best-in-Class​

Best-in-class screening rests on a specific theory about how capital allocation creates change. If investors preferentially direct capital to the best-managed companies within each sector — including sectors that produce some harm — those companies benefit from lower costs of capital relative to their less well-managed peers. Over time, this differential creates an incentive: companies that want access to ESG-investor capital must improve their ESG practices relative to sector peers.

This engagement-through-capital theory argues that best-in-class is more likely to drive real corporate improvement than sector exclusion, because:

  1. Best-in-class investors remain present in sectors where capital allocation decisions affect company behavior
  2. The ESG scoring creates a transparent, competitive benchmark that companies know they are being evaluated against
  3. Capital cost differentials within a sector (best vs. worst ESG performer) are more likely to be meaningful than the broad sector effect of exclusion

Critics respond that remaining investors in problematic sectors — even with the "best" companies — provides legitimacy that enables those sectors to continue operating. An oil company that holds the sector's best ESG score is still an oil company.

Real-world examples​

MSCI ESG Leaders Indices: MSCI's ESG Leaders index series applies best-in-class methodology to select approximately the top 50% of companies by ESG score within each GICS sector group, subject to controversy exclusions. The resulting indices cover about 500–600 companies from the MSCI World parent (approximately 1,600 companies), maintaining sector diversification while tilting toward higher ESG quality. These indices underlie several of the world's largest ESG ETF products.

CalPERS total fund ESG approach: CalPERS uses a combination of exclusion (tobacco, under California law) and ESG integration/tilting across its remaining portfolio. For the bulk of its equity holdings, it maintains sector diversification while using ESG signals to adjust security selection within sectors — a best-in-class-adjacent approach applied at the world's second-largest US pension fund.

Transition-focused best-in-class: Some ESG fund managers have evolved toward "ESG momentum" or "transition" best-in-class — selecting companies whose ESG scores are improving rather than those that are already highest-rated. This approach holds the theory that capital should flow toward companies taking transition seriously, even if they haven't yet achieved high ESG levels — and that companies improving from a lower base may offer both ESG progress and financial upside as the market reprices their improving profiles.

Common mistakes​

Assuming best-in-class is always preferable to exclusion: Best-in-class is preferable for investors who prioritize diversification and lower tracking error. It is less appropriate for investors with strong values-based objections to entire industries — no best-in-class methodology produces a portfolio free of fossil fuels or tobacco. The choice between approaches depends on the investor's values intensity and tolerance for tracking error.

Overlooking the ESG rating methodology in best-in-class products: Best-in-class portfolios are only as good as the ESG rating on which "best" is defined. A fund using an ESG rating that heavily weights disclosure over performance could be selecting companies that are best at reporting ESG, not necessarily best at ESG management. Understanding the underlying methodology is essential.

Ignoring the dynamic nature of best-in-class rankings: Companies' ESG rankings within their sector change over time. Index rebalancing may require selling companies that have dropped in relative ESG standing — creating turnover costs. ESG momentum within the sector (which company is improving fastest) may be as important as current absolute standing.

FAQ​

What is the difference between best-in-class and ESG integration?​

Best-in-class selection removes companies with below-median ESG scores from a universe before portfolio construction. ESG integration uses ESG factors as inputs throughout the investment process — affecting valuation, risk assessment, and portfolio weighting — without necessarily removing low-ESG-scoring companies. Both approaches use ESG data, but their mechanism differs: best-in-class uses ESG as a gate; ESG integration uses it as one variable among many.

Does best-in-class ESG screening produce better returns than the unscreened market?​

Evidence is mixed. Best-in-class ESG portfolios have often performed comparably to or slightly better than their parent indices — partly because selecting companies with better management quality (one component of ESG) is consistent with selecting more durable businesses. However, results depend heavily on the period analyzed, the ESG scoring methodology used, and the sector weighting effects of the selection process.

How large is the active share typically in best-in-class ESG portfolios?​

Best-in-class ESG portfolios typically have active shares of 15%–35% relative to their parent indices — lower than most active equity strategies (which average 60%–80% active share) because the selection process retains a large share of the index by market weight. This relatively low active share reflects the approach's primary goal: maintaining broad market exposure while adding an ESG quality tilt.

Can best-in-class be combined with negative screens?​

Yes — and often is. Many products first apply absolute exclusions (cluster munitions, tobacco), then apply best-in-class selection within the remaining universe. This combination achieves both strong values alignment on specific categorical issues and sector-diversified quality tilting within the remaining universe.

How frequently do best-in-class portfolios rebalance?​

Most best-in-class ESG indices and products rebalance annually or semi-annually, coinciding with the update cycle of the underlying ESG ratings. Some products with controversy overlays update more frequently when significant controversy events occur. Annual rebalancing creates turn-over costs that are typically small for broad-market products but can be more significant for concentrated best-in-class strategies.

Summary​

Best-in-class (positive) screening selects the highest-ESG-quality companies within each sector rather than excluding entire industries. It maintains sector diversification — reducing tracking error relative to exclusion approaches — while tilting toward better-managed companies. The approach rests on the theory that capital allocation within sectors creates stronger improvement incentives than wholesale exit. Its primary limitation is that it retains investments in sectors with fundamental sustainability concerns, requiring investors to accept that the "best oil company" or "best tobacco company" belongs in a sustainable portfolio. Whether that compromise is acceptable depends on the investor's values framework and investment objectives.

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