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ETF News And Commentary

Although emerging markets investments have gained significant interest among investors from the developed nations in the past decade, it is traditionally considered to be a riskier proposition than domestic U.S. investments. This is primarily due to the fact that most of these nations are commodity-centric economies which makes them highly susceptible to any downtrend in the global economy.

Also, emerging market investments can take a severe hit from the appreciation in the U.S Dollar versus the domestic currency in which the asset (i.e. stocks/bonds) of the ETF are denominated. This causes returns to take a beating due to negative currency fluctuations even if the underlying asset class generates positive returns (see Currency Hedged ETFs: Top International Picks?).

Thus, currency risk is an ever present concern for investors seeking exposure in the emerging markets space.

Despite these facts, the iShares MSCI Emerging Markets ETF (EEM) and Vanguard MSCI Emerging Markets ETF (VWO) have been extremely popular among U.S. investors in the past decade. In fact, these two ETFs are among the top 5 largest ETFs (in terms of assets under management) behind only the SPRD S&P 500 ETF (SPY) and the SPDR Gold Trust (GLD), combining to account for more than $100 billion in AUM.

This is in itself an astonishing achievement, which is highlighted even further considering the fact that both these ETFs are less than a decade old. Nevertheless, this kind of sums up the paradigm shift in the risk-return expectations and investment discipline of the U.S. investors in the past decade where most of the focus was shifted from the developed nations to the developing (emerging) economies, primarily in the quest for higher returns and portfolio diversification.

Interestingly these two exciting emerging market ETFs currently track the same index, the MSCI Emerging Markets Index which measures the equity market performance of various emerging markets ― both have very little to chose from in terms of country holdings. However, over the course of the next few months Vanguard seeks to switch over to an index created by index provider FTSE known as FTSE Emerging Index.

This is primarily aimed to reduce index related costs up to a great extent which if materialized, would bring down further its already paltry expense ratio thereby strengthening its competitive advantage in the expense front.

Presently, the country allocations for both EEM and VWO are almost the same with double digit exposure to countries like China, South Korea, Brazil and Taiwan. Some of the other top allocations include South Africa, India and Russia (see Can Anything Stop These Southeast Asia ETFs?).

However, the new index i.e. the FTSE Emerging Index, is almost the same as the MSCI Emerging Market Index with the exception of one big factor—South Korea. This is especially true considering FTSE has been a strong believer that South Korea belongs to the developed markets space instead of emerging markets. Thus names like Samsung Electronics and Hyundai Motors will be missed from the new VWO.

While this brave move sure seems to have its own pros and cons, one thing remains certain. This will create some sort of differentiation between the almost identical emerging market ETFs on the investment objective and methodology front while catering to the similar target market. Therefore, in the future we can expect even more competition between the two.

Nevertheless, these emerging markets economies have come across as vital contributors to the overall global economic growth. In fact, the rising population and increasing per capita income in these economies make them accountable for a bulk of global consumption (read Access the $30 trillion Consumer Market with These ETFs).

At first glance, these two products can be thought of as perfect substitutes for one another, especially considering the massive similarity between them. However, a closer look reveals differences that can go a long way in influencing investor decisions.

The table below summarizes some of their differences:

 

Data Points

EEM

VWO

Inception

4/11/2003

3/10/2005

Total Assets

$41.93 billion

$57 billion

Expense Ratio

0.67%

0.20%

Yield

1.95%

3.39%

Average Daily Volume

45.5 million shares

19.7 million shares

No. of Holdings

844

898

In Top 10 holdings

16.26%

18.4%

Net Asset Accumulated in 2012

$5.66 billion

$10.6 billion

Annualized Standard Deviation

27.23%

26.20%

Beta (Vs. S&P 500)

1.32

1.26

R-Squared (Vs. S&P 500)

82.14%

81.35%

YTD Returns (30th November 2012)

11.47%

11.34%

Zacks Rank

3 (Hold)

2 (Buy)

It can be argued that VWO by Vanguard was probably an answer to iShares’s EEM. This strategic maneuver by Vanguard was probably to play on the price point and deliver a low cost offering to the same target market providing a well diversified equity pure play in the emerging market space.

The move did seem to pay off as VWO, which was launched two years after EEM, has managed to amass more in terms of asset base, probably in large part thanks to its lower expense ratio (see Forget China, Buy These Emerging Market ETFs Instead).

From a risk-return tradeoff perspective, both the ETFs seem to mirror images as both of them exhibit similar risk-return characteristics. However, it is noteworthy that none of the emerging market ETFs has provided international diversification benefits to the investors as both VWO and EEM have strong R-Squared values of around 82% against the U.S. equity markets represented by the S&P 500 Index (read Do Country ETFs Really Provide Diversification?).

Also, both these ETFs have generated impressive returns of around 11.5% over the current fiscal year. While VWO has managed to generate these returns by amassing a net of $10.6 billion in fiscal 2012, EEM has managed to deliver similar returns by amassing just $5.66 billion for the same period.

This indicates that VWO is probably more volatile in terms of asset accumulation than EEM and is generally marked by volatile asset sell-offs (more than that of EEM) during a downtrend (read ETFs in a QE3 World).

EEM on the other hand seems to be enjoying a steadier following of investors who probably don’t rush in to sell the positions during a downtrend. Also, from a liquidity point of view, EEM clearly seems to be leading the race as it has an average daily volume of more than double that of its Vanguard counterpart.

However, the single biggest factor which seems to go in favor of VWO is its low cost structure which is expected to go down further once the index switch over takes place, this not only helps to reduce the annual management fees substantially, but also results is lower tracking error and helps to bring the cost of investments down. Also, VWO pays a superior yield of 3.39% compared to EEM paying just 1.95%.

These two characteristics probably sets the ETFs apart as far as total effective returns to investors is concerned, as a high expense ratio reduces the effective returns and a higher yield magnifies it. Considering these factors together VWO clearly seems to be better placed than EEM. This is also reflected in our analysis by a Zacks Rank of 3 or ‘Hold’ for EEM compare to a Zacks Rank of 2 or ‘Buy’ for VWO.

Nevertheless, the fairly liquid equity markets of the emerging economies with low levels of correlation with the developed country equity markets coupled with typically high yields (due to the high interest rate scenarios) will continue making them attractive destinations for aggressive as well as income seeking investors in the near future.

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