Emerging Market ETF: VWO or EEM

Last year, I made some changes to a portion of my wife’s IRA account that’s held at Scottrade. What I did was I sold a couple of mutual funds I still owned in the account and bought one ETF instead. For the past few years, I have used Scottrade’s systematic purchase plan to buy shares of these funds every quarter after moving most investments, those already invested in Vanguard mutual funds, to Vanguard. Though Scottrade has a lowered pricing plan for using automatic plan to buy mutual funds, I still had to pay a $2 fee for each transaction. Not a lot of money (Scottrade charges $14 for non-automatic mutual fund purchase), but still something that can be avoided. The ETF I ended up buying wasVanguard Emerging Markets Stock ETF (VWO), a fund that I have kept an eye on for quite a long time. I am a big fan of foreign/emerging markets funds, so having one in the IRA account makes sense.

When it comes to what to buy in the emerging markets category, there are two popular ETFs to choose from. In addition to VWO, I also looked at iShares MSCI Emerging Markets Index ETF (EEM). Actually, the two funds have a few things in common, starting from the same underlying index they track, the MSCI Emerging Markets Index. Yet, they follow different investment philosophies which result in difference in investment costs and discrepency in returns. Looking at the comparison chart below, EEM seems to track the index (Bloomberg:MXEF) more closely in the 1-year period, though . If a longer observation period is applied (EEM was incepted in 2003 and VWO was launched two years later in 2005), VWO has an edge over VWO in terms of returns. According to Morningstar, VWO has a 5-year annualized NAV return of 9.50% comparing to EEM’s 8.87%.

Emerging market ETFs

You may ask if both funds track the exact same index, how come they differ on returns?

There are two factors that cause the discrepancy between the returns of VWO and EEM. One is tracking error and the other is the fund’s expense ratio (ER), the cost for the fund manager to operate the fund.

Tracking Error

Even though both EEM and VMO track the same index, EEM only own a subset of the index’s entire stock holdings while VWO hold the complete set in the fund. At some points in the past, such as in 2008 and 2009, EEM held about half of the index’s 796 components (as of 01/31/2011). The reason for EEM to only hold a portion of the index’s components can be explained by the way the fund selects which companies to invest. Since the MSCI Emerging Markets Index is a benchmark weighted by market caps of the underlying companies, its direction can be largely determined by its heaviest members. Therefore, by only holding companies with the largets weightings in the index, EEM uses a sample apporach that tries to capture the movement of the index without holding every stock. And this creates tracking error for EEM. In contrast, VWO follows the index much more closely since it holds the index’s every underlying stock in its portfolio.

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However, EEM seems to have changed its investment strategy. From iShares website, the fund held 764 stocks at the end of January. This should reduce the tracking error down the road.

Expenses

Vanguard is known to have rock bottom expenses in both the mutual fund and ETF arenas and it’s no exception for VWO, which has an expense ratio of 0.22%. EEM. On the other hand, the ER of EEM is 0.69%, more three times that of VWO. Both funds have quite low ERs in the emerging market category and in the short term, the impact of the difference in ERs on an investor’s portfolio could probably be ignored. However, in the long run, it’s a different story, especially if the funds are held in a retirement account. For example, if you invest $10,000 now and assume an annual return of 8%, then using FINRA’s Fund Analyzer, you can see the difference between the market values of the funds in 10 or 20 year caused by the difference in ER alone.

EEM vs VWO

After 10 years, if you redeem your investments, you would have $20,149.96 in EEM with a total fee of $999.62 and $21,119.52 with a total fee of $327.22.

I guess these differences can explain why VWO, 2 years younger than EEM, has become the largest emergying market ETF.

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One Response to “Emerging Market ETF: VWO or EEM”

  1. Dr. Timothy Lawler |  Feb 21, 2011 at 1:04 pm

    Great post. I agree that emerging market ETFs are the way to go, and you have to love Vanguard’s options. They will pretty much beat the competition on mutual funds every time. Please keep the good stuff coming! What a great resource!