ETF Of The Week: Unexpected Horse Race

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:

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.

Difference Of 10%

However, what ultimately may influence tracking error more than the strategies SUSL and USSG use to track their indexes is how much of these funds' portfolios are allotted to tracking their indexes.

In USSG, at least 80% of net assets are used to track the securities in the ETF's benchmark—leaving up to 20% free to be invested in other securities not in the index, but which the manager believes will help improve fund performance. These can include cash and cash equivalents, money market instruments and derivatives, such as futures, options, swaps and so forth.

It's a nigh-universal caveat in ETF-land; and SUSL includes similar language in its prospectus. Except in SUSL, at least 90% of the fund's assets will be used to track securities in the benchmark, not 80%. Meaning, only 10% or less may go toward these nonindex-related securities.

Will it matter? Only time will tell. But keep your eye on tracking error for these two funds. These tiny discrepancies in how each ETF tracks its index could explain any disconnects that arise.

Total Cost Of Ownership

Of course, what most investors likely will notice first about these two ETFs is the difference in price tag. USSG has an expense ratio of 0.10%, while SUSL has an expense ratio of 0.15%.

Given what we've seen of the fee wars thus far, many investors may not look any further at these funds than that. But expense ratio doesn't tell the whole story on costs. Trading spreads matter as well.

USSG has an average spread of 0.16%, which is relatively high for a large and midcap fund. SUSL, though it has only been trading for about a week, has an average trading spread of roughly half that, at 0.07%.

Real Spider-Man?

Which of these two almost identical ETFs will have staying power long term? Maybe both. That's the bet Ilmarinen is making, at least; the pension company not only helped develop both products, but then poured close to $1 billion into each at launch to help drive their success.

But at the moment, we're reminded of the internet meme of Spider-Man pointing at Spider-Man. The only way to figure out which is the real Spider-Man of these two ETFs is by keeping an eye on their future flows.

Contact Lara Crigger at [email protected]