iShares has overhauled its flagship SRI ETF range…

What Has Changed?

Recent changes have been made to increase transparency, improve diversification and reduce tracking error relative to the parent MSCI indices.

Transparency

In the ranking of eligible securities, ESG trends are no longer taken into account. This adjustment makes it easier to understand why certain stocks are included. All eligible companies with the highest ESG ratings are now included in the target index, where previously some were excluded in favor of companies with lower overall ratings but a higher ESG trend score.

Improving the diversification of the sector

The top 25% of securities by number in each sector in the eligible universe are now selected. This is in addition to the existing rule of selecting 25% of the free-float market capitalization of each sector in the parent index. This change prevents any one large constituent from dominating a sector.

Reduced tracking error relative to the parent index

The previous 5% single stock limit has been replaced. Now, no constituent can exceed +3% of its weighting over the parent index, with an absolute cap of 18%. In addition, a new limit ensures that each sector’s weight cannot deviate by more than +/- 1% from the corresponding sector’s weight in the parent index. These measures aim to correct some of the more egregious single stock and sector bets and align the SRI indices more closely with the parent index.

Next steps for the sustainable evolution of the index strategy

The recent changes to the iShares SRI ETF Europe range are the latest in a series of strategy changes implemented since the launch of the first strategy in 2016.

In the table below, we present the evolution of the SRI strategy through changes in key indices.

The changes have evolved towards greater complexity with the addition of new layers of screening and scoring over time. For example, the ESG Trend Score, which rewards companies with improved ESG profiles, was added to incentivize the improvement of target companies in 2018. The latest update, which removes this score, marks a notable shift towards simpler, more transparent ESG solutions and explainable.

Why were the changes implemented?

Recent updates have been made to address several prevailing concerns among clients regarding ESG investing.

Widespread underperformance

After more than a decade of net inflows, European-domiciled equity ETFs tracking MSCI SRI strategies saw net outflows in 2023, a trend that continued into 2024.

For example, in the second quarter of 2024, the iShares MSCI USA SRI ETF saw outflows of $1.74 billion (£1.33 billion), the second largest among European sustainable funds. Various factors, including rising global geopolitical tensions and rising demand for traditional energy, have led to widespread underperformance and a broader reassessment of ESG investments.

Minimizing tracking error while maximizing ESG exposure

Investors tend to prefer ESG or SRI portfolios that closely align with their parent index while maintaining strong ESG credentials. Strategies with the highest ESG scores can deviate significantly from the broader market, leading to substantial differences in performance due to individual stock bets or persistent sector and geographic overweight/underweight.

Increasing demand for transparency

As ESG strategies become more complex due to improved data availability and the need to differentiate product offerings, it has sometimes been difficult to determine why certain companies are chosen over others. This has led investors to demand greater transparency.

What is Impact?

While we view these changes as generally positive, they haven’t moved the needle when it comes to the funds we evaluate. However, the impact of these changes was different across the range.

iShares MSCI USA SRI ETF

• Morningstar Rating: Bronze
• Morningstar Category: US Large Cap Mixed Stocks
• Current fee: 0.20%

The removal of ESG trend criteria allowed the inclusion of Nvidia (NVDA), one of the world’s largest companies, which had previously been excluded. Under the old methodology, stocks with a positive ESG trend ranked higher than those with a neutral trend. Despite consistently having the highest ESG scores in 2020, Nvidia was rated with a neutral ESG trend and was excluded. At the end of July 2024, Nvidia holds a 9.51% weighting in the MSCI USA SRI Select Reduced Fossil Fuels Index.

In this fund, previous broad sector trends have been corrected through issuer and sector cap adjustments. For example, prior to these changes, the MSCI USA index had a technology sector weight of about 30%, while the SRI index had only about 10% technology exposure. Now, both indexes have technology that makes up about a third of the total portfolio.

Despite containing approximately 30% of the approximately 600 components of the MSCI USA index, the fund retains many of the core characteristics of the parent index. The iShares backtest shows that active distribution and tracking error were largely unaffected.

Previously, the process pillar of this fund was above average as it had a broadly diversified market capitalization weighted portfolio. Although the portfolio has been improved due to methodology changes, this fund still has weaknesses that limit the Process Pillar rating to above average.

iShares MSCI EM SRI ETF

• Morningstar Rating: Neutral
• Morningstar Category: Global Emerging Markets Equities
• Current fee: 0.25%

Fortunately, previous large deviations of sector weights relative to the parent index, particularly for the financials, technology and consumer discretionary sectors, have been largely eliminated. This was due to the introduction of a sector cap of +/-1% compared to the parent index and the change in the issuer cap.

However, the differences between the benchmark’s country weights have widened further. The resulting structural underweights to China (10%) and overweights to Taiwan (10%) relative to the MSCI Emerging Markets Index will be key drivers of the fund’s future performance.

Despite the changes, the fund still trails more than 1,100 of the 1,300 components of the parent index, and backtesting by iShares indicates the index’s active share and tracking error will remain high. These limitations contribute to maintaining the fund’s process pillar rating at Below Average.

iShares MSCI Japan SRI ETF

• Morningstar Rating: Bronze
• Morningstar Category: Japan Large Cap Stocks
• Current fee: 0.20%

The iShares MSCI Japan SRI ETF maintained an average pillar process score following the strategy change.

The most positive change was the +/- 1% cap on sectoral differences relative to the parent index. This has largely eliminated significant bets in the healthcare and consumer discretionary sectors from the MSCI Japan index.

Adding 25% of the number to the existing top 25% of market capitalization of ESG markers per sector also helps to reduce the concentration of single stocks in sectors, while moving from a fixed cap of single stocks (5%) to a relative one (+/- 3%) reduces potential bets taken against some of the biggest stocks. That led to a 1.5% increase in the weight of electronics giant Sony ( SONY ).

While we welcome these changes, the fund’s core characteristics, such as holdings, turnover and tracking error (back-tested) against the MSCI Japan index, remain largely unchanged.

Finally, the strict ESG exclusion criteria mean that this fund still takes significant single-stock bets against the broader market, limiting our confidence in its ability to outperform over longer periods. That said, it still provides low-cost and largely representative exposure to Japanese stocks in a peer group where passive strategies have proven hard to beat.

Conclusion

Recent adjustments to these funds’ benchmark methodologies are designed to address the current challenges many ESG funds face. For the three funds we evaluate, these changes are generally positive. However, despite the changes to the ETF portfolios, the updates did not lead to any changes in the process pillar ratings.