When I heard about the $57 billion Vanguard MSCI Emerging
Markets ETF (NYSEArca:VWO) dropping the MSCI Emerging Markets Index
for the FTSE Emerging Index, my first thoughts were favorable.
That's mostly because I've questioned for some time South
Korea's "emerging" status in MSCI's index.
That said, the coming changes aren't enough to alter my tune
about VWO or, for that matter, the iShares MSCI Emerging Markets
Index Fund (NYSEArca:EEM).
I've always thought comparing VWO and EEM was like comparing two
identical apples with simply different stem lengths. They track the
same index and, for the retail investor, VWO probably made more
sense simply because it's so much cheaper than EEM.
I think I've made it clear in recent blogs that I'm not exactly
a fan of either VWO or EEM. While EEM was certainly the fund to own
over the past decade-VWO didn't launch until 2005-I think there are
now better emerging markets ETF options with more potential for the
Still, VWO and EEM are the third- and fourth-largest ETFs in the
world, and Vanguard's switch to FTSE comes with some serious
material differences that should be discussed.
There's a lot to cover here, so I'm going to point out the main
differences most relevant to the retail investor that will separate
the new VWO from EEM.
FTSE's "developed" classification of South Korea is by far the
biggest difference here. Not only did FTSE upgrade South Korea to
"developed" status three years ago, S&P long ago upgraded South
Korea to classify it as a developed market as well.
MSCI still classifies South Korea as "emerging," which is why
the country has about a 15 percent weighting in EEM and the current
VWO. But once VWO switches over to the new FTSE index, the 15
percent weighting will be reallocated to the remaining countries in
the index. (Thankfully, that transition will take place
Looking ahead, it's worth noting that MSCI currently has South
Korea and Taiwan on its watch list for possible upgrades to
"developed" status. Should that happen, which seems inevitable,
both of those countries would eventually leave EEM.
Meanwhile, MSCI has Greece on a watch list to be downgraded to
emerging, meaning EEM investors might see some Greek companies in
their fund in the coming years. Qatar and UAE are on watch to be
upgraded from frontier to emerging, so those two gulf states might
appear in EEM as well.
On the FTSE side, like MSCI, Taiwan is on watch to be upgraded
to developed-country status and Greece is also on watch to be
downgraded to emerging.
But that's where the similarities in their watch lists end.
FTSE has Poland on watch for upgrade to a developed market and
Kuwait to be upgraded to emerging, meaning investors who hold on to
VWO through the transition might see Polish companies taken out and
Kuwaiti companies added.
The exclusion of South Korea would inevitably mean investors in
the new VWO would lose exposure to Korean mega-caps like Samsung,
Hyundai, Posco and Kia.
But beyond South Korean firms, exposure to certain Chinese
companies classified as P-chips might also be lost. P-chips are
nonstate-owned Chinese companies incorporated outside of the
mainland, most often in certain foreign jurisdictions (Cayman
Islands) and traded in Hong Kong.
While MSCI includes P-chips in its indexes, FTSE currently
classifies P-chips as Hong Kong companies, meaning they're excluded
from the FTSE Emerging Index.
VWO may lose exposure to some significant P-chips like Tencent
Holdings, Want Want China and Belle International.
It's worth noting that FTSE recently announced a
reclassification of P-chips to China, so beginning in March 2013,
P-chips will be reviewed for possible inclusion into the FTSE
Cost Wars And Schwab's SCHE
Interestingly, the $515 million Schwab Emerging Markets Equity
ETF (NYSEArca:SCHE), which also tracks the same FTSE index that VWO
will track, made headlines last month when Schwab cut the expense
ratio on the fund by 25 percent to 0.15 percent, undercutting VWO
by 5 basis points.
The timing was quite interesting. VWO has been taking
significant market share away from EEM for years, mostly due to its
much lower expense ratio.
Now, only two weeks after SCHE's fee-cut announcement, it looks
like VWO is looking to slash again, as much of this index change
was attributed to lowering costs.
My guess is that VWO will be cutting its expense ratio
again-probably after the transition to the FTSE index is complete.
I'd guess that VWO's new price might match or even undercut SCHE's
To put all this into context, my guess is that to the average
investor, these changes will mean very little, notwithstanding some
big differences in country exposure.
When all is said and done, I expect to see VWO and EEM still
being the No. 3 and No. 4 ETFs by assets for a while.
Still, to me, the real question is, Why invest in VWO or
Even excluding the South Korea factor, both indexes are heavily
weighted in China, Brazil, Taiwan and South Africa. As these
countries rapidly developed over the past decade, the funds'
correlations in returns to the broad equity markets have also
Smaller Is Better
I think it's starting to make more sense to look at smaller
emerging markets and even some frontier markets poised for higher
growth in the next decade.
For example, ETFs such as the new EGShares Beyond BRICs ETF
(NYSEArca:BBRC) as well as country-specific ETFs focused on
countries like Turkey, Poland, Indonesia, Thailand and the
Philippines look promising.
If you're looking at the frontier space and willing to take on
the extra risk, the iShares MSCI Frontier 100 Index Fund
(NYSEArca:FM) also looks promising.
Or, if you want to stay with the BRICs, the dividend-weighted
WisdomTree Emerging Markets Equity Income Fund (NYSEArca:DEM) has
also done well compared with EEM and VWO.
More broadly, how much do the MSCI and FTSE emerging markets
indexes really differ when it comes to returns? Over the past three
years-a good time period to look at because FTSE upgraded South
Korea to "emerging" in 2009-they barely look different.
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