ETF Of The Week: Unexpected Horse Race

May 17, 2019

Earlier this week, we reported on the iShares ESG MSCI USA Leaders ETF (SUSL), which launched on May 9 with a massive amount of cash from Finnish pension company Ilmarinen (read: "New ESG ETF Has Blockbuster Debut").

That net inflow, worth $847 million, allowed SUSL to squeak past the Xtrackers MSCI U.S.A. ESG Leaders Equity ETF (USSG) to become the largest ETF launch of the past 15 years (read: "ESG ETF's Launch Biggest In 15 Years").

It's a horse race few expected. Two environmental, social and responsible (ESG)-focused ETFs dueling it out for which could make the bigger market splash wasn't on the radar.

However, happen it did; and SUSL's inflow alone has bumped up the net assets invested in socially responsible ETFs 8% to a total of $11.6 billion invested. That's a notable jump, considering that as of the end of 2018, ESG ETFs had only $7.9 billion invested. SUSL is now the fourth-largest ESG ETF, just behind USSG:

 

Top 5 Largest ESG ETFs
Ticker Fund Expense Ratio AUM MSCI ESG Rating
DSI  iShares MSCI KLD 400 Social ETF 0.25% $1.35B 7.50
SUSA  iShares MSCI U.S.A. ESG Select ETF 0.25% $972.95M 8.73
USSG  Xtrackers MSCI U.S.A. ESG Leaders Equity ETF 0.10% $864.47M N/A
SUSL  iShares ESG MSCI USA Leaders ETF 0.15% $837.47M N/A
ESGD  iShares ESG MSCI EAFE ETF 0.20% $789.17M 8.05

Source: ETF.com. Data as of May 16, 2019. (MSCI ESG Ratings range from 0-10, with 10 being the highest score)

 

For that reason alone, we're making SUSL our ETF of the Week. But to put SUSL into context, we also need dig into what makes USSG tick.

SUSL: Slightly More Aggressive On ESG

What makes SUSL and USSG so interesting is that, functionally, there's very little to separate the two rival funds.

Both ETFs track large and midcap U.S. companies selected from the MSCI USA Index. Both ETFs use benchmarks that score and rank those stocks using ESG factors. And both ETFs screen out any company involved in controversial industries, such as tobacco, alcohol, gambling, controversial weapons and so on.

In fact, SUSL's benchmark, the MSCI USA ESG Extended Leaders Index, is a variant of USSG's index; the main difference is that it uses more aggressive exclusionary screens for civilian firearms makers. In addition to screening out any producer of civilian firearms, the Extended Leaders benchmark also excludes companies earning $20 million in revenue or more from civilian firearms-related products, and those earning 5% or more of their revenues from the distribution of civilian firearms-related products.

There are other minor distinctions between the funds as well.  

For example, only companies with an MSCI ESG rating of "BB" or higher are eligible to be included in SUSL's portfolio. That's one step higher than USSG's benchmark, which pulls from companies rated "B" or higher. Effectively, this means all stocks in the MSCI USA Index are fair game for USSG, except the worst ESG offenders.

Similarly, to remain in SUSL's index, stocks must have a MSCI ESG Business Controversy score of "3" or higher on a 0-10 point scale. Meanwhile, USSG uses a cut-off of 2. The difference is slight, but it is there.

Representation Vs. Replication

Intriguingly, SUSL's prospectus states that the fund will use a representative sampling method to track its index, meaning the fund managers don't have to buy up each security in the benchmark at the precise weight in which it appears.

Instead, they may invest in a sample of securities selected to have the same fundamental, liquidity and return profile as that of the underlying index (read: "How To Run An Index Fund: Full Replication Vs. Optimization").

Sampling can reduce portfolio management costs, but it also runs the risk of introducing tracking error between the fund and its index. (That hasn't been the case for many of the iShares ETFs that use this strategy, however.)

USSG, meanwhile, uses full replication, meaning it purchases each of the securities in the underlying benchmark at their appropriate weights.

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