iShares makes unorthodox play for the ESG ETF market

Australia has three new ESG ETFs trading on its exchanges following iShares’ decision to add its name to the growing sustainable funds sector. However, you'd be forgiven for not noticing. Rather than launching distinct funds which adopt ESG principles, like many of its competitors, iShares has instead opted to change the benchmarks of two of its existing global equity ETFs to ESG Leaders indexes.

The funds affected are the popular iShares Core MSCI World All Cap ETF IWLD and iShares Core MSCI World All Cap AUDH ETF IHWL. Both have been rebranded as of 8 June. Under the change, IWLD becomes the iShares Core MSCI World ex Australia ESG Leaders ETF, aiming to track the MSCI World ex Australia Custom ESG Leaders Index, while IHWL becomes the iShares Core MSCI World ex Australia ESG Leaders (AUD Hedged) ETF, aiming to track the MSCI World ex Australia Custom ESG Leaders Index (AUD Hedged).

IWLD and IHWL funds will now only invest in companies that have high MSCI ESG ratings. Companies involved in severe ESG-related business controversies will be excluded, while others who engage in business activities like fossil fuels, tobacco and alcohol will be screened out.

Collectively, the funds manage almost $500 million on behalf of investors which will instantly flow into the $27 billion sustainable investment sector.

As for the third fund, iShares chose a more traditional path, launching an Australian equity focused ESG ETF – the iShares Core MSCI Australian ESG Leader ETF IESG - which began trading on Friday 4 June. With a management fee of 0.09 per cent, it is the cheapest fund to offer this type of exposure and signals iShares’ readiness to compete for ESG dollars.

IWLD Then and Now

Source: BlackRock

In a release to the ASX, iShares affirmed its investment conviction in sustainability-integrated investment portfolios, saying they can "better provide risk-adjusted returns to investors".

"...with the impact of sustainability on investment returns increasing, we believe that sustainable investment will be a critical foundation for client portfolios going forward."

Back-testing of the new custom ESG leaders benchmark against the performance of the previous MSCI World benchmark (excluding management fees) shows outperformance between May 2019 and December 2020.

Raised eyebrows

Investor reaction to the changes has been mixed. IHWL retail investor Rodney Campbell says he's "fine" with the shift to the ESG benchmark but noted he only holds a small allocation.

"The fact that this only forms up to 5 per cent of my portfolio may also have some influence," he told Morningstar.

"If it was like 40 plus per cent of my portfolio like it presumably is for some people (using this instead of say VGS/VGAD/VESG/etc) you might care more."

Ike, a retail ETF investor, said he was happy with the new benchmark saying, "I want to invest in a global ETF at low cost without holding arms manufacturers and coal miners". He will seek to buy the fund post-distribution.

Others have been less positive. John, a retail investor with a substantial portion of his portfolio in the iShares funds, says he has nothing against ESG but was frustrated that he was not given a choice. He's now unsure whether he will remain with the fund.

"I was initially excited to see that some of the issues with the fund were being addressed like direct replication and tax drag and then I saw the ESG aspect and realised the rug had been pulled out from underneath us," he told Morningstar.

"The issue is my portfolio has its underlying philosophy and the approach substantially changed without an ounce of control from myself. I'm not sure why they didn't create a new product alongside it.

"As to if I'll stay, I don't know yet. There's so much competing info on ESG. I dislike the subjective nature of it even though the methodologies appear to make an attempt at being objective. And what if their ethics don't match mine?

"I was actually considering a tilt [to ESG] prior to this. I just wanted to do it on my own terms. [This experience] has really opened my eyes to the risks we can put in fund managers."

John said he would recommend the product to someone looking for broad ESG exposure "if they keep the fees low".

Similar sentiments were shared on investor forums like Reddit and Whirlpool where some community members described the changes as "disappointing". Others wondered if this move signalled the future direction of ETFs, as funds globally integrate ESG criteria into their investment philosophy and process.

A spokesperson for iShares said the reaction from investors had been overwhelmingly positive.

"BlackRock has engaged with clients and investors on these enhancements and received positive response. Less than 1 per cent of unitholders have queried the change.

“We have provided broad and diversified global equity building blocks as long-term allocations in portfolios at a very competitive price point in line with client feedback.

"We believe these exposures are positioned to build scale as investors increasingly incorporate ESG considerations including climate as a key investment decision in their portfolio construction process.”

'Under Review'

Morningstar analysts have placed both IWLD and IHWL "Under Review" until they have met with iShares. Analyst Zunjar Sanzgiri said investors should be aware the new benchmark has a higher allocation to technology stocks and a low allocation to the energy and utilities sector under the ESG ratings and exclusion rules.

"We plan to meet with iShares in the coming weeks and will update our view shortly after," he said. "In the interim, we are placing this strategy Under Review."

IWLD previously held a Silver Morningstar rating while IHWL was rated Gold.

IWLD Sector Breakdown

Source: IWLD Fact Sheet 30 April 2021, BlackRock

Major companies excluded

Large companies that appeared in the IWLD May 18 portfolio but not in the June 8 portfolio with the new index include Amazon, Facebook, Berkshire Hathaway, and JPMorgan. 

The MSCI World ex Australia Custom ESG Leaders Index benchmark is a free float-adjusted market capitalisation weighted index. The index uses MSCI ESG ratings to identify companies that have demonstrated an "ability to manage their ESG risk and opportunities". Companies will be required to have an MSCI ESG rating of “BB” or above to be eligible for inclusion.

The index also uses MSCI ESG controversy scores to identify companies that are involved in very serious controversies involving the ESG impact of their operations and/or products and services. Companies must have a controversy score of 3 or above to be eligible for inclusion.

Exclusionary screens are also applied to companies engaged in controversial business activities including fossil fuel extraction, gambling, nuclear power, thermal coal power and alcohol.

IWLD Holdings | Top 10

Source: BlackRock

The ETFs will also change the way they invest. Prior to 8 June, the funds aimed to replicate the MSCI World Investable Market Index via holdings in four iShares ETFs, each covering a different region, which held stakes in around 4000 companies. Now, they will hold physical underlying securities (over 700 companies). iShares says this shift will enable the fund to "more accurately replicate the index's performance". The new indexes also exclude Australian companies from the portfolio – after previously having a 2.35 per cent exposure.

As part of the transition, the fund will realise net capital gains it receives from the sale of its iShares ETF investments. They will be included in the fund's distributable income for the year ending 30 June. iShares says that most of the investments it will seek to sell will have been held for 12 months or more. As such, the realised capital gains should be eligible for the capital gains discount.

Management costs will remain the same - IWLD will charge 0.09 per cent a year; and IHWL 0.12 per cent a year.

Making a play

iShares has been under pressure to launch ESG ETFs down under. Several of its passive competitors including BetaShares, Vanguard, VanEck and State Street have launched ESG ETFs in Australia over the past few years garnering significant interest from investors.

BlackRock, the owner of iShares’, has cast itself as a climate change leader and pledged to double its ESG ETFs and incorporate ESG in all its strategies. This move to altering the underlying index could be viewed as pushing ESG into the mainstream, using it as a core holding rather than a thematic.

At the end of first-quarter 2021, Morningstar estimates that retail assets invested in Australasian sustainable investments were $27.9 billion. This is an 8 per cent increase compared with 31 December 2020 and a 54 per cent increase compared with 31 March 2020. Estimated first-quarter flows of $1.5 billion was the second highest on record, only topped by fourth-quarter 2020 flows of $1.9 billion.