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3 ESG Funds Graduate to Full Coverage from Morningstar’s Prospects List

These are the ESG funds our analysts think are worth watching.

Morningstar's manager research analysts maintain Morningstar Prospects, a list of up-and-coming or under-the-radar fund managers and strategies that the team believes may have enduring advantages and long-term appeal. Prospects typically have not been subject to full qualitative analyst coverage in the past but may merit such coverage in the future.

In the July 2020 edition of the list, three strategies with environmental, social, and governance (or ESG) criteria graduated to full coverage: an equity exchange-traded fund, a core bond ETF, and an equity index fund.

Fidelity U.S. Sustainability Index (FITLX)
Fidelity U.S. Sustainability Index Fund, which earns a Morningstar Analyst Rating of Bronze, effectively targets stocks with strong corporate governance and sustainable environmental and social practices. Over the long term, this low-cost strategy should compete well versus the broad U.S. market and most funds in its large-blend Morningstar Category. The fund tracks the MSCI USA ESG Leaders Index, a list of large- and mid-cap U.S. stocks with the strongest ESG characteristics relative to their sector peers. This sector-relative approach to stock selection gives the Fidelity fund a diversified portfolio.

MSCI tailors its ESG ratings to each industry, focusing on the risks and opportunities that could be material to long-term financial performance. This helps it identify risks that may not be apparent in traditional financial metrics. Such risks include litigation, regulatory changes, changing consumer preferences, climate change, or the lack of a diverse workforce.

The fund’s focus on financial materiality distinguishes it from a strict values-based approach, though it makes some values-driven exclusions, such as firms that generate significant revenue from the sale of alcohol, gambling, tobacco, nuclear power, or weapons. Even so, this compelling ESG fund produces a well-diversified portfolio and levies modest fees.

iShares U.S. Aggregate Bond ETF (EAGG)
Silver-rated iShares ESG U.S. Aggregate Bond ETF offers broad exposure to the U.S. investment-grade bond market with a subtle tilt toward corporate issuers with strong ESG characteristics.

This index strategy targets issuers with strong ESG characteristics relative to their sector peers while keeping tracking error low relative to the Bloomberg Barclays U.S. Aggregate Bond Index. The fund invests in U.S. Treasuries and investment-grade securitized, corporate, and government-related bonds issued in U.S. dollars. Like Fidelity US Sustainability Index, this fund relies on MSCI’s ESG ratings, which incorporate financially material ESG risks relative to issuers' sector peers. To be eligible for the portfolio, the corporation or sovereign entity must receive average or higher ESG scores.

To mitigate unintended bets, the fund anchors the weighting of each broad bond sector to the index. Consequently, AAA rated Treasuries and agency mortgage-backed securities account for 40% and 26% of the portfolio, respectively, giving the fund low exposure to credit risk. It also tries to keep duration (a measure of interest-rate risk) in line with the index.

Silver-rated iShares ESG MSCI USA ETF is a solid, low-cost strategy that favors firms with strong ESG practices while mitigating active risk. The ESG fund tracks--but does not fully replicate--the MSCI USA Extended ESG Focus Index. Its active share against its parent index is currently only 27% but it has nearly identical sector weightings. These constraints keep the portfolio’s composition and performance close to that of the broad market and help diversify its risk exposures relative to more-concentrated portfolios. Yet its ties to an ESG index put its Morningstar Sustainability Rating in the large-blend category's top quartile.

Like the other Prospects graduates, the ESG ratings underpinning this fund’s stock selection are tailored to each industry, focusing on financially material risks and opportunities. This industry-relative focus improves comparability. For example, it may consider packaging material and waste to be a material factor in the soft-drink industry but not the banking industry, where privacy and data security are more important. Corporate governance, however, factors into all firms' ESG ratings.

To achieve its tracking error objective, the fund uses an optimizer, which limits how far stock and sector weightings can deviate from those of the broad market. These constraints could cause the portfolio to hold stocks in sectors that some socially conscious investors may find objectionable, such as energy. However, firms that generate significant revenue from the sale of tobacco, petroleum drawn from oil sands, thermal coal, firearms, and controversial weapons aren’t eligible for inclusion.

This article is adapted from research that was originally published in Morningstar Direct's Research Portal. If you're a user, you have access. If not, take a free trial.

Nicholas Goralka does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.