ESGU: Dip Your Toes Into ESG Investing Without Sacrificing Results

Summary

• Many investors aren't ready to concede returns just to avoid so-called "morally bankrupt" stocks, but with ESGU, you won't have to, as it tracks the MSCI USA Index almost perfectly.
• MSCI's optimization constraints ensure this, and the majority of excluded stocks have negligible weightings in the S&P 500.
• ESGU's popularity is a reflection of this; it has assets under management of $22 billion with annual fees of just 0.15% and is an appropriate substitute for S&P 500 funds.

Ivan Martynov/iStock via Getty Images

Investment Thesis

Like dividend investing, value investing, and growth investing, ESG investing can be done on a spectrum. You can invest in stringent ESG funds or try out some "ESG-lite" funds that put a bit of emphasis on environmental, social, and governance factors, but not enough to significantly change the risk and return profile of a target Index. The iShares ESG Aware MSCI USA ETF (NASDAQ:ESGU) is very much in the latter category, which is likely why it's so popular and has managed to slightly outperform the MSCI USA Index in the last 15 years.

For me, this is welcome news, as I'm skeptical that ESG factors - mainly environmental ones - are advantageous from an investment perspective. As frustrating as that stance is for ESG proponents, I'm still going to give ESGU a good review due to its methods for controlling risk and return relative to its parent Index. This article's primary purpose is to put investors' minds at ease about ESG, as socially responsible investing doesn't always have to mean accepting inferior returns.

ESGU Overview

Basics

iShares lists the fund's investment objective on its website as follows:

The iShares ESG Aware MSCI USA ETF seeks to track the investment results of an index composed of U.S. companies that have positive environmental, social and governance characteristics as identified by the index provider while exhibiting risk and return characteristics similar to those of the parent index.

In addition, the fund has the following characteristics:

• Index: MSCI USA Extended ESG Focus Index
• Expense Ratio: 0.15%
• Dividend Yield (TTM): 1.14%
• Assets Under Management: $21.95 Billion
• MSCI ESG Fund Rating (AAA-CCC): A
• MSCI ESG Quality Score - Peer Percentile: 75.39%
• MSCI ESG Quality Score (0-10): 6.7
• Equity Holdings: 327
• Largest Sector: Technology (29.33%)
• Concentration In Top 10: 27.74%

Methodology

The fund's one-pager gives an overview of its selection process:

Source: iShares ESGU One-Pager

To simplify things, it starts with the MSCI USA Index, which has over 600 constituents and eliminates about half of those companies through a combination of exclusions (controversial weapons, civilian firearms, tobacco, thermal coal, oil sands) and an Index optimization method. A near-perfect risk and return profile (relative to the MSCI USA Index) is achieved by applying certain optimization constraints. I've listed the most important ones below, taken from the MSCI Extended ESG Focus Indexes Methodology document.

• Active Sector Weights: +/- 5%
• Active Constituent Weights: +/- 2%
• Minimum Constituent Weight: 0.1%
• Predicted Tracking Error: 0.5%

The purpose of the relatively low active sector and constituent weight constraints is to ensure that the Index's risk and return profile isn't too different than the MSCI USA Index. The 0.1% minimum constituent weight constraint functions to eliminate the vast majority of holdings. To put this into context, 289 constituents in the S&P 500 have weightings of less than 0.1%, and while the MSCI USA Index is about 25% larger to include some mid-caps, the effect will still be significant.

All of this culminates in a predicted tracking error of just 0.5%. This means that in each year, you can expect ESGU's performance to be almost identical to the MSCI USA Index, which, in turn, is nearly identical to the S&P 500. I'll go over this tracking error in more detail later.

Sector Exposures and Top Holdings

Below are ESGU's sector exposures, showing that most are in Technology, Health Care, and Consumer Discretionary stocks. Together, these three sectors total 53.97% of the fund vs. 53.04% for the iShares Core S&P 500 ETF (IVV).

Source: iShares ESGU Fund Overview

ESGU's top ten holdings account for 26.26% of the fund, as shown below, compared to 27.98% for IVV.

Fundamentals Snapshot

Finally, to further support the argument that ESGU is an acceptable substitute for the S&P 500, here is a snapshot of the fund's top 20 holdings, with net metrics for the entire fund against SPY's shown in the final row.

Source: Created By Author Using Data From Seeking Alpha

You can see that the concentration among the top 20 holdings is near identical (36.16% vs. 38.37%, as are the weighted average market capitalization and 60-month beta figures. ESGU's current constituents have also performed better in the last five years and have marginally different weighted average forward revenue growth rates, EPS growth rates, and dividend yields.

Performance

vs. MSCI USA

Although ESGU only launched less than five years ago, MSCI makes Index data available back to June 2006. Here is a chart comparing the ESG Focus Index with the MSCI USA Index.

Source: Created By Author Using Data From MSCI Performance Data

You can see that the two are virtually identical even with a 15-year lookback. Here are some additional statistics I calculated showing that MSCI's optimization methods have worked quite well over the years. In addition, the average annual return difference between the two Indexes was only 0.19%, and in the last three calendar years, it has been in favor of the ESG Focus Index.

Source: Created By Author Using Data From MSCI

vs. ESG Alternatives

MSCI's performance tool allows you to compare against other ESG-themed Indexes, too. The chart below compares ESGU's tracked Index (MSCI USA ESG Focus) against three others with a base value of 100.

Source: MSCI Performance Charting Tool

As shown, the USA ESG Focus Index has fallen about in the middle of the pack, returning about 137% in the last five years, or 18.84% annualized. The best-performing Index in this sample was the USA ESG Select Index, whose annualized returns were 19.50%. Finally, and perhaps ironically, the worst-performing was the USA ESG Screened Index with annualized returns of 18.38%. For me, the latter's relatively poor performance suggests that analysts and Index providers, as a whole, may not have a firm understanding of what specific factors make ESG-friendly companies better investments - hence, my skepticism.

ESG Ratings Differ, Sometimes Substantially

We've established that ESGU is very likely to match the risk and return levels of broad-based Indexes like the S&P 500 Index and the MSCI USA Index. The following is a list of the top ten companies that ESGU excludes:

1. Walmart (WMT)
2. Wells Fargo (WFC)
3. Philip Morris International (PM)
4. Boeing (BA)
5. Charter Communications (CHTR)
6. Stryker (SYK)
7. Altria Group (MO)
8. Lockheed Martin (LMT)
9. Duke Energy (DTE)
10. General Motors (GM)

This list is consistent with MSCI's ESG rating system - excluding companies Philip Morris, Altria Group, and Lockheed Martin are obvious choices for exclusion. However, don't assume that MSCI's view about ESG factors is necessarily the "correct" view. Consider this table, taken from a piece published by Research Affiliates, showing how individual "E," "S," and "G" ratings can differ widely.

Source: Research Affiliates

As shown, there appears to be much more agreement among providers on environmental factors rather than social and governance factors. The paper's authors highlighted Wells Fargo as an example of how one provider could score it so well and the other could score it so poorly. There's also this paper, dated December 29, 2020, which showed only an average 0.54 correlation between ESG providers (and a range of 0.38 to 0.71). Not surprisingly, the authors noted that " the information that decision-makers receive from ESG rating agencies is relatively noisy."

Investment Recommendation and Conclusion

The main point I wanted to make was that ESG investing is done on a spectrum, not unlike value, growth, dividend, or any other investing style. It just so happens that ESGU is based on an Index that, according to its methodology, can't deviate much from its parent Index made up of U.S. large- and mid-cap stocks. Performance analysis of 15 years confirms this, as does my analysis of its current constituents showing virtually identical fundamental metrics. Use ESGU as a substitute for the S&P 500 without fear, and if it makes you feel better about your investments, go for it. It's impossible to put a number on this emotional benefit, but I reckon it's something more than zero for most people.

Talk of risk premiums being higher for non-ESG-friendly companies may be fun, but ultimately, it's useless at this stage. A key reason is that there is little agreement on what constitutes a good ESG score. We can't even agree on which factors are most important and likely never will because a lot is subjective. It's not like discussing fundamentals, where, for example, we can all agree that high sales growth is better than low sales growth. If ESG matters to you, you'll have to decide what factors matter to you the most and then choose an appropriate provider.

The Index that ESGU tracks is meant for those wanting to dip their toes into the world of ESG. Get a feel for what it's like to not invest in companies like Walmart, Philip Morris, or Lockheed Martin, and see how little it changes the actual results. To that end, it succeeds. However, if you're a serious ESG investor who wants only the "best of the best" ESG companies (as MSCI sees it), then ESGU isn't for you. Just be prepared for a much different set of returns.

Disclosure: I/we have a beneficial long position in the shares of IVV, SPY, WMT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.