SUSA - ESGU: $5 Billion Outflow This Month Prompts ESG Skepticism

2023-03-29 17:28:52 ET

Summary

• ESGU follows a sector-neutral strategy designed to mimic the risk and return profile of the broader market. With $14 billion in assets, it's the largest ESG fund in the world.
• Still, the fund had $5 billion in outflows this month, leading all ETFs. Likely reasons are unclear investment objectives and relatively poor returns over the last three years.
• ESGU remains one of the better choices, but only because it's nearly identical to SPY, excluding only 3% of companies by weight. All other key fundamental metrics are similar.
• There isn't a compelling reason to buy ESGU today. Since S&P 500 ETFs like SPY, IVV, VOO, and SPLG are cheaper, investors should be slightly better off with them in the long run.

Investment Thesis

According to the 2022 Annual ESG Survey by Russell Investments, 236 surveyed respondents cited climate risk, general environmental concerns, and diversity, equity, and inclusion as the most significant ESG issues impacting clients. Still, practical investors aren't always willing to sacrifice return or pay higher fees. Despite what I've heard anecdotally from some financial advisors, I doubt most clients will knowingly accept lower returns in exchange for being a responsible investor, the benefits of which need clarification.

The iShares ESG Aware MSCI USA ETF ( ESGU ) is one solution for those wanting to test a mild version of the strategy, although it's without any measurable benefit. ESGU's expected volatility, growth, and valuation metrics are similar to the SPDR S&P 500 ETF ( SPY ), and its sector-neutral approach means the fund's composition is nearly identical. In my view, ESGU is too similar to market funds to make a difference for investors, both socially and financially. Until the industry can define and demonstrate the benefits of ESG investing, I don't recommend buying ESGU, and I look forward to taking you through my reasons in more detail below.

ESGU Overview

Strategy Discussion and Key Exposures

ESGU tracks the MSCI USA Extended ESG Focus Index, selecting stocks that maximize exposure to ESG factors but staying within a 0.50% target tracking error relative to the MSCI USA Index. Constituents have a minimum 0.05% weight at each rebalancing, and the Index excludes the following industries:

• Tobacco
• Controversial Weapons
• Civilian Firearms
• Thermal Coal
• Oil Sands

In addition, companies involved in "very serious business controversies" are excluded. The Index framework is here , but the ten most prominent ones impacted by these exclusion criteria are below.

1. Walmart ( WMT )
2. Philip Morris International ( PM )
3. The Boeing Company ( BA )
4. Lockheed Martin ( LMT )
5. Stryker ( SYK )
6. Analog Devices ( ADI )
7. Altria Group ( MO )
8. The Southern Company ( SO )
9. Duke Energy ( DUK )
10. Boston Scientific ( BSX )

Still, these companies have a combined 3.16% weighting in SPY. The largest stocks remain because it's too difficult to maintain a similar risk and return profile by excluding them. ESGU's top ten holdings list is below; the average absolute difference in weighting per stock compared with SPY is just 0.16%.

At best, investors may figure ESGU is worth owning because it's the same as SPY but excludes a few controversial names. However, others may see ESGU as insufficient. As its name indicates, ESGU is for those "aware" of ESG issues but not necessarily looking to make an impact. I previously described ESGU's 0.15% expense ratio as reasonable, but S&P 500 Index funds ( SPY , IVV , VOO , SPLG ) are even cheaper, so I can't make a good buy case.

We see the impact of ESGU's sector-neutral approach in the table below. I also included sector exposures for the iShares MSCI USA ESG Select ETF ( SUSA ) for comparison purposes. SUSA has a different composition in Consumer Discretionary, Consumer Staples, Financials, Industrials, Technology, and Communication Services. It also has a 0.95% average absolute difference with SPY for its top ten holdings.

On the other hand, ESGU's sector exposures are nearly identical in all cases except for Financials and Technology. These differences are due to how the sectors have performed since March but will reset to target weights in June.

Performance Analysis

Since January 2017, ESGU has gained an annualized 11.38% vs. 11.88% and 11.49% for SUSA and SPY. The two ESG ETFs had slightly higher volatility, likely due to more Technology sector exposure.

To determine whether the ESG strategy has outperformed, consider the following periodic returns through February 2023 for 25 ETFs with "ESG" listed as the primary strategy, according to FactSet Research. The list is limited to those with at least three years of history.

There are only 13 ESG funds with at least a five-year track record, but ESGU's 59.05% gain ranked fourth-best behind SUSA, DSI , and ESG . ESGU's 38.80% return over the last three years slightly lagged SPY, but the difference is negligible. Interestingly, after a poor showing in 2018-2019, the top-performing fund over three years was the Point Bridge America First ETF ( MAGA ), with a 63.48% total gain. MAGA likely attracts more anti-ESG investors. Nevertheless, shareholders benefitted from low exposure to Technology stocks last year, and the fund outperformed ESGU by 19.23%.

ESGU Analysis

The following table highlights selected fundamental metrics for ESGU's top 25 industries, updated to reflect the last GICS changes effective earlier this month. These industries total 66.14% of the portfolio compared to 72.10% and 66.84% for SUSA and SPY.

Since ESGU and SUSA have higher Technology exposure, their five-year betas are slightly above market, but nothing significant. The same is true for most key metrics. Constituents have grown sales by an annualized 11.75% over the last five years, though expected sales, EBITDA, and earnings growth rates are closer to 8%. ESGU trades at 24.09x forward earnings, the highest of the three, while its 9.18/10 profitability score is the most disappointing factor. SPY's is 9.36/10, and other value-oriented funds like the Vanguard Dividend Appreciation ETF ( VIG ) are above 9.40/10.

VIG has about 14% allocated to S&P 500 stocks ESGU excludes, so it's not the best comparison. Still, ESG investing is done on a spectrum. Rather than let an Index provider decide what's responsible, scan through an ETF's holdings list and decide for yourself which companies are off-limits.

Investment Recommendation

ESGU offers no clear advantage over cheaper S&P 500 Index funds because it follows a sector-neutral strategy that aims to replicate a broad market Index's risk and return profile. My fundamental analysis demonstrated that the growth and valuation profile is nearly identical to SPY. Furthermore, future returns should be similar because the fund excludes only 3% of S&P 500 companies by weight. In effect, you'll pay more in fees, likely won't make much of an impact from an ESG perspective, but could still be labeled an ESG client for next year's Annual ESG Survey.

I'm uncertain about what the future of ESG investing holds. However, my analysis reveals only 31% of ESG-themed large-cap stocks outperformed SPY over the last year, 25% over the previous two years, and 35% over the last three years. This underperformance may be why ESGU watched $5.25 billion exit this month. Until the industry clearly defines responsible investing and how it can benefit investors socially and financially, ETFs like ESGU don't deserve your capital. Thank you for reading, and I look forward to answering any questions in the comments section below.

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