ESGU - ESGU: No Value-Add And ESG May Just Mean Executive Rents

2023-08-30 13:44:18 ET

Summary

• iShares ESG Aware MSCI USA ETF is not a very helpful fund in our opinion.
• The ESGU ETF closely matches the sectoral distributions and exposures of the iShares Core S&P 500 ETF, but levies higher expenses.
• There are economic concerns and reasons to worry about overall market valuations on top of the relative inefficiency of ESGU.

The iShares ESG Aware MSCI USA ETF (ESGU) is interesting because the companies that feature highly are not those we'd consider very ESG (environmental, social, and governance) oriented. As we detailed in our last article , there are plenty of "dirtier" companies from a green perspective in ESGU. It brings up some important points, which is what makes a company ESG after all.

Ultimately, with ESGU being specifically built with companies determined as ESG by the index provider, there are even wonders around structural issues that may make ESG companies less attractive for shareholders in some respects, outside of the fact that powerful forces like governments may bestow economic benefits on ESG companies. Executive rent and gaming ESG could become a growing issue in corporate governance. At any rate, ESGU is ultimately very close to the general U.S. value-weighted index. We have concerns about U.S. market valuations.

ESGU Breakdown

Let's start with a comparison between iShares Core S&P 500 ETF (IVV) and ESGU .

The exposures match closely between IVV and ESGU. The sectoral distributions are close to being identical as well. Ultimately, ESGU is a value-weighted U.S. index, meaning lots of high multiple tech exposures. The ESGU P/E is 22x, and the ESGU expense is just 0.15%, compared to IVV's 0.03%.

It's worth beginning with general comments on the levels of the current markets. The Fed made a speech that essentially acknowledged the balancing act between inflation fighting and economic prosperity as per its dual mandate. Still, more rate hikes are on the table in the short term, and deglobalization as well as other trends that are inherently inflationary create rate lift in the longer term that is becoming gradually more recognized by markets based on the yield curve. All of this puts outsized pressure on high multiple stocks whose valuations reside in the tail end of the horizons, which are going to be most sensitive to cost of capital assumptions.

Then there is the matter of whether the Fed really will be able to get away with a soft landing, with perhaps only one more rate hike to go considering that the last leg of inflation will be more stubborn, with base effects now passed. Higher rates and a poorer economy with lagged effects from the rate hikes already exercised may be in the near future - stagflation. At 22x P/E in the market, there seems to be no pricing of these possibilities.

Bottom Line

AI has driven much of the rally, but monetizing it could become difficult as creators and content owners close ranks around the issue of copyright and training sets. There are economic risks still in the market.

These are worries about the market overall, but picking ESGU over IVV anyway seems indefensible. In addition to the higher expense ratios for no value-add at the moment, it is not certain that investors would even want ESGU to have divergent allocations. ESG ratings are questionable even in principle, and the creep of ESG metrics into matters of corporate governance and capital allocation could face backlash as it makes its way into executive compensation schemes as well . While ESG may correlate to more progressive companies that get high values like tech, it may also skew allocations towards businesses that are more likely to have managements levying executive rent.

ESGU is just not a very helpful ETF comparing it to the IVV, where even the IVV is not a sure pick right now.

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