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A Compelling Approach to ESG Investing

ESG investing is a tough nut to crack. There is no agreed upon standard of what constitutes strong environmental, social, and governance practices. What's socially responsible to one investor may not be to another. Consequently, there's no one single approach to ESG investing that will work for everyone. That said, iShares ESG MSCI USA Leaders ETF is one of my favorites.
This strategy has a lot going for it. It focuses on financially material ESG risks and opportunities within each industry, which could make it more palatable for investors who are more interested in long-term investment value than nonfinancial values. And this is one of the cheapest ESG funds around. SUSL has moderate active risk, so it could serve as a core U.S. stock holding. It uses a simple stock-selection approach with no explicit constraints that force it to own industry laggards, though it may still own some fossil fuel companies. While it isn't as well diversified as broad-market index funds, this is a strong option overall.
Morningstar Take
Over the long term, this low-cost strategy should deliver competitive performance with the broad U.S. market and better performance than most funds in the large-blend Morningstar Category. It earns a Morningstar Analyst Rating of Silver.
This exchange-traded fund delivers on its ESG mandate but keeps many advantages of traditional index funds--a low fee, low turnover, and a broad market-cap-weighted portfolio harnessing the market's collective wisdom. It tracks the MSCI USA Extended ESG Leaders Index, which targets large- and mid-cap U.S. stocks representing half the market with the strongest ESG traits relative to sector peers. This sector-relative approach allows for more-effective screening and mitigates unintended sector bets. The resulting portfolio has modest active risk relative to the broad MSCI USA Index, which should keep it competitive in the long term with the broad U.S. large-cap market.
The strategy's underlying ESG ratings are tailored to each industry, focusing on the most relevant ESG risks and opportunities that could affect long-term financial performance. For example, packaging material and waste is more relevant for consumer-oriented firms than it is for banks. That factor may influence the ESG ratings in the soft-drink industry, but not in banking, where privacy and data security are more relevant.
The focus on financial materiality distinguishes SUSL from a strict values-based approach, but it applies some values-driven exclusions. Firms that generate significant revenue from alcohol, gambling, tobacco, nuclear power, and weapons aren't eligible for inclusion. Similarly, firms caught up in significant controversies (like the Wells Fargo bogus account scandal) aren't eligible.
Risk reduction from the fund's ESG screens is partially offset by the diversification it forgoes. This is still a well-diversified portfolio, but it has considerable exposure to its largest holding, Microsoft. This is a compelling choice for socially conscious investors, especially as it's one of the cheapest large-cap funds.
Process
This strategy balances broad market exposure against its ESG mandate. It diversifies risk, mitigates turnover, and harnesses the market's collective wisdom about the relative value of its holdings. It earns an Above Average Process Pillar rating.
The fund replicates the market-cap-weighted MSCI USA Extended ESG Leaders Index, which targets stocks from the broad MSCI USA Index representing half of the market with the strongest ESG characteristics relative to sector peers. This screen is powered by MSCI's ESG ratings, which focus on ESG risks and opportunities in each industry. A firm's exposure to these risks and opportunities and how it is managing them influence this assessment. The ESG ratings consider the most relevant factors for each industry, which should improve their efficacy, as many industries face different ESG risks. Corporate governance is universally relevant, so those factors go into all firms' ESG ratings.
The ESG ratings are tailored to each GICS subindustry, but the fund's stock selection occurs at the sector level. This may lead to industry tilts, but it keeps the fund’s sector weightings in line with the broad market's, which mitigates exposure to unintended sources of risk. It also improves comparability relative to a sector-agnostic approach. But this means the fund has exposure to fossil fuel companies. Alcohol, gambling, tobacco, nuclear power, and weapons firms are excluded, as are firms involved in controversies.
Portfolio
This portfolio gives up diversification by excluding half the market, but it is still well diversified. Its top 10 holdings are less than one third of the portfolio. That said, it has considerable exposure to Microsoft and Alphabet, as it does not cap the weightings of its holdings. It would be better if it did.
Stocks in this portfolio should be less susceptible to ESG risks that can affect profitability--litigation, brand degradation, potential environmental and workplace regulatory changes, and physical risks from climate change. Some holdings may even benefit as consumers and employees increasingly prefer more environmentally friendly products and socially conscious business practices.
But it's not clear that these stocks will offer higher or lower returns than the market. Firms' ESG risks are not a secret. To the extent that those risks affect performance, the market should price them. But many investors don't put long-term ESG risks on par with factors more relevant to short-term performance, so it may be these risks aren't getting the attention they should.
This portfolio looks a lot like its parent index. Its holdings trade at similar valuations to the MSCI USA Index, and it has a similar market-cap orientation and sector weightings. But its holdings generate slightly higher returns on invested capital, suggesting they are more profitable, which may help long-term performance.
Turnover is very low, owing to the market-cap-weighted approach and buffers to mitigate unnecessary trades.
Performance
The fund has a short record, but it has gotten off to a strong start. From its inception in May 2019 through May 2020, the fund beat the MSCI USA Index by 1.67 percentage points annually, with slightly lower volatility. This was partially due to more favorable stock exposure in the industrials and financial-services sectors.
The portfolio's active risk relative to the MSCI USA Index has been modest and should continue to be. This is because its active share is around 50% and it has similar sector weightings to that benchmark.
Alex Bryan, CFA does not own shares in any of the securities mentioned above.

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