Key Takeaways

• iShares ESG Aware MSCI USA Small-Cap ETF (ESML) earns a five-star rating from CFRA based on its low risk and high reward potential relative to US Core Equity peers.
• The portfolio consists of many appealing stocks based on our fundamental analysis, including Quanta Services (PWR) and Williams-Sonoma (WSM). The ETF excludes companies involved in certain environmentally and socially unfriendly businesses.
• CFRA expects ESML to outperform the broader category in the next nine months based on our fund-level and holdings-level analytics.

Fundamental Context

The CFRA Focus ETF for April is iShares ESG Aware MSCI USA Small-Cap ETF (ESML). In rating equity ETFs, CFRA combines fund-level attributes, including performance and costs, with holdings-level risk and reward analysis to provide a second opinion on what is inside the fund. The ESG ETF universe has expanded rapidly, with nearly half of the 126 ETFs rated by CFRA at the end of February having launched in the last three years. ESML began trading in mid-April 2018 and provides investors with a strong small-cap alternative that adheres to ESG values and attempts to achieve client investment goals.

The index-based ETF is built by first excluding the following categories: tobacco; controversial weapons; producers and retailers of civilian firearms; certain fossil fuels-related activity, such as the production of thermal coal, thermal coal-based power generation, and the extraction of oil sands; and companies involved in very severe business controversies. From there the index incorporates a quantitative process to maximize exposure to companies with higher ESG ratings while maintaining risk and return characteristics like those of the parent MSCI index.

For each industry, MSCI identifies key ESG issues that can lead to substantial costs or opportunities for companies, such as climate change, resource scarcity, and demographic shifts. Then MSCI rates each company’s exposure to each key issue and analyzes the extent to which they have developed robust strategies and programs to manage ESG risks and opportunities. MSCI scores companies based on both their risk exposure and risk management. To score well on a key issue, MSCI assesses management practices, management performance governance structures, and/or implications in controversies, which are taken as a proxy for overall management quality.

While the transparency of what occurs behind the scenes is limited, the resulting portfolio is well-diversified at the security and sector level. For example, CFRA Strong Buy recommended Quanta Services (PWR *****) and Buy recommended Williams Sonoma (WSM ****) were recent top-10 constituents in the 1,046-stock portfolio but were each less than 0.40% of assets. Industrials (17% of assets), Consumer Discretionary (15%), Information Technology (15%), Health Care (15%), and Financials (14%) were the most represented sectors, but the fund held stakes in Energy (3%) and Utilities (2%), including Buy recommended Diamondback Energy (FANG ****) and MDU Resources (MDU ****).

CFRA’s qualitative STARS recommendations do not explicitly focus on a company’s ESG traits, but corporate governance, particularly a company’s accounting practices, is a core feature of our bottom-up investment process. We believe some ESG investors would prefer a small-cap ETF with little to no exposure to fossil-fuel related sectors and we think the diversification will help limit the tail risk.

In the one-year period ended March 29, ESML rose 94%, slightly ahead of the 93% for iShares Russell 2000 ETF (IWM) and slightly behind the 96% gain for iShares Core Small-Cap ETF (IJR). ESML, which charges a modest 0.17% fee for an alternatively weighted ETF, added $170 million of net inflows in the past year and had $730 million in assets.

Conclusion

Overall, CFRA finds the risk and reward attributes of ESML to be appealing based on its performance record and what is inside the fund. We think the ETF is positioned to outperform the U.S. Core Equity category over the next nine months, regardless of its ESG focus. But for investors seeking to build an asset allocation strategy built on an ESG framework, ESML is worthy of consideration and is currently used in CFRA’s ESG ETF model portfolio. To learn more, visit https://go.cfraresearch.com/ESG or click on the portfolios tab of MarketScope Advisor.

Todd Rosenbluth is Director of ETF & Mutual Fund Research at CFRA.