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INsider: Emerging markets ETFs just got complicated

Largest fund switches indexes; meanwhile, alternative choice adds alternative

Oct 17, 2012 @ 11:39 am

By Jason Kephart

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Altered states: Korea out of Vanguard fund ((Photo: hyku))

Investing in emerging markets through exchange-traded funds has gotten a whole lot more involved over the past two weeks.

An index change by Vanguard Group Inc. and a new low cost option from BlackRock Inc.'s iShares means advisers no longer have the luxury of just choosing the cheapest path to the MSCI Emerging Markets Index.

Vanguard was the first to shake up the emerging markets landscape by announcing a change in the underlying index of the $57 billion Vanguard MSCI Emerging Markets ETF Ticker:(VWO) to the FTSE Emerging Markets Index to lower overall costs.

Vanguard's emerging markets ETF is the largest in the industry and has taken in almost 70% of inflows into that exchange-traded fund category through the end of September, according to Lipper Inc.

The biggest difference between the two index providers is their classification of South Korea. MSCI considers it an emerging market, while FTSE has upgraded it to developed.

Not only will advisers have to decide if they're okay with swapping MSCI's definition of emerging markets for FTSE's, they're going to have to deal with the transition between the two indexes. The change will result in the ETF selling its 15% stake in investments in Korea, including top holding Samsung Electronics Co LTD, and buying more exposure to countries such as Brazil, Taiwan, and South Africa.

The moves will take place over several months, to lessen the impact of the trading costs. In the meantime, the performance will be somewhere in between the two indices as it makes the switch.

The index switch seemed to open a window of opportunity for the second largest emerging markets ETF, the $37 billion iShares MSCI Emerging Markets ETF Ticker:(EEM). Despite charging an expense ratio of 67 basis points, more than triple the cost of Vanguard's emerging markets ETF, the iShares ETF is the only game in town for advisers or institutions that benchmark portfolios to MSCI indices.

However, this week iShares announced it was launching the iShares Core MSCI Emerging Markets ETF Ticker:(IEMG) as part of a new initiative to target buy-and-hold investors. The new emerging markets fund will cover a wider universe of emerging markets stocks, including some small-caps.

Despite the extra exposure, iShares doesn't expect the performance of the two emerging markets indices to deviate significantly over a long time period, though short-term outperformance of one or the other is likely. In making the switch to FTSE, Vanguard also said it didn't expect a big change in performance over time, though again, over short-time periods, it's a coin flip between which index will outperform.

What is notable about the new iShares emerging markets ETF is the cost. At 17 basis points, it's going to be three basis points cheaper than the Vanguard ETF, and 50 basis points cheaper than iShares' existing emerging markets ETF.

If the three indices used by Vanguard and iShares are likely to perform more or less in line with each other over a long time period, cost is most likely going to be the deciding factor for many advisers. That's exactly what's driven the success of the Vanguard ETF. It's had almost $10 billion of inflows this year, compared to $1.2 billion for the iShares ETF, according to Lipper Inc.

Even with Vanguard's big lead in inflows, the two emerging markets ETFs are clearly the top choices for emerging markets ETFs. Combined, they attracted just about $4 out of every $5 invested in emerging markets ETFs this year.

More options, especially cheaper ones, are always a good thing for advisers. But in this case, it's also going to require some extra homework.

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