Emerging-markets ETFs just got complicated

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

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

Vanguard was the first to shake things up by announcing a change in the underlying index of its $57 billion Vanguard MSCI Emerging Markets ETF to the FTSE Emerging Markets Index to lower overall costs.

Vanguard's emerging-markets ETF is the largest in the industry and took in almost 70% of net inflows into that ETF category through the end of last month, 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 are OK with swapping MSCI's definition of emerging markets for FTSE's, they will have to deal with the transition between the two indexes. The change will result in the ETF's selling its 15% stake in investments in Korea and buying more exposure to countries such as Brazil, South Africa and Taiwan.

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 indexes during the switch.

WINDOW OF OPPORTUNITY

The transition seems to have opened a window of opportunity for the second-largest emerging- markets ETF, the $37 billion iShares MSCI Emerging Markets ETF. 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 indexes.

However, last week, iShares said that it was launching the iShares Core MSCI Emerging Markets ETF 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 indexes 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 said that it doesn't expect a big change in performance over time.

What is notable about the new iShares emerging-markets ETF is the cost. At 17 basis points, it will be 3 basis points cheaper than the Vanguard ETF and 50 basis points cheaper than iShares' existing emerging-markets ETF.

The Vanguard ETF has had almost $10 billion of inflows this year, compared with $1.2 billion for the iShares ETF, according to Lipper.

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

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