Although exchange traded funds increasingly provide an inexpensive way for financial advisers to gain access to international markets, analyzing such ETFs is more difficult than analyzing those that stick to domestic securities.
Consider the iShares MSCI Emerging Markets Index ETF (EEM) from
Barclays Global Investors of San Francisco.
With more than $28.48 billion in assets and good absolute returns, it is one of the most popular ETFs. Nevertheless, some advisers question whether it is truly the best broad emerging-market ETF money can buy, due to its tracking error or divergence from its benchmark.
The fund was up 35.62% year-to-date through last Wednesday. Over the same period, its benchmark — the MSCI Emerging Markets Index — was up 40.24%, according to Morningstar Inc. of Chicago.
Tracking error has been a surprisingly persistent problem for the ETF, particularly because ETFs are supposed to hew closely to their underlying index.
The fund had posted a one-year return of 45.66% through last Wednesday, versus a one-year return of 50.95% for its benchmark, according to Morningstar.
The ETF's three-year annualized return of 36.54% compares with a 37% return for its index over the same period.
"That the tracking error is so wide is disheartening," said Mark Balasa, co-president of Balasa Dinverno & Foltz LLC in Itasca, Ill.
"It does make us leery," said Sean Clark, chief investment officer of Clark Capital Management Group Inc. of Philadelphia.
There are two reasons for the tracking error, said Matt Hougan, editor of indexuniverse.com in New York.
The iShares fund doesn't own the entire index but instead samples a portion of it, he said.
And some overseas markets, such as Brazil and Malaysia, don't allow for "in-kind" redemptions, a process crucial to many ETFs in which redemptions are paid in shares of the fund's underlying stocks rather than cash.
As a result, the fund is underweighted in those countries, which is partly responsible for its recent underperformance, Mr. Hougan said.
But not all ETFs face such problems.
The $25.78 billion Vanguard Emerging Markets ETF (VWO) offered by
The Vanguard Group Inc. of Malvern, Pa., strives to own the entire MSCI Emerging Markets Index, Mr. Hougan said. And because VWO is actually a share class of a Vanguard mutual fund, it doesn't rely on the creation and redemption feature to do business in countries that may not allow that, he said.
As a result, VWO has more closely tracked the index.
It was up 42.52% year-to-date through last Wednesday, and had a one-year return of 51.99%, according to Morningstar. The fund made its debut in February, 2005 and hasn't yet attained a three-year annualized return.
That VWO more closely tracks its index, however, doesn't make it a better fund.
For example, there are cost savings to owning fewer stocks, said Christine Hudacko, a spokeswoman for
Barclays. The
Barclays fund is more tax-efficient, and transaction costs are kept to a minimum, she said.
"We've made the determination that we wanted to track the index, but we did not want to do it if it was going to interfere with tax efficiency and transaction costs," Ms. Hudacko said.
As the number of international ETFs grows, such issues could cause greater headaches for advisers.
Forty-seven international funds have made their debuts this year, bringing the total to 123, according to Morningstar.
And many more are planned.
For example, this month, Chicago-based
Northern Trust Global Investments filed a prospectus for 27 ETFs with exposure to a wide range of international and global markets.
The filing includes 20 country-specific funds, four international real estate investment
trust funds and three global funds.
Advisers and others are divided as to whether this abundance of international funds is necessary.
The global ETF for which Northern Trust has filed — the broad-market NETS Dow Jones Wilshire Global Total Market ETF — is generating some excitement as the first of its kind.
But it may be a little too broad for some advisers.
"For us, the use of an all-in global fund is less appropriate," Mr. Balasa said. "We want to be able to pick and choose the weightings."
That doesn't mean picking and choosing among the dozens of single-country funds, which Mr. Balasa said he views as too risky.
When choosing a single-country fund, there are political issues to take into account — issues with which Mr. Balasa said he isn't always familiar.
Other advisers, however, believe strongly in single-country funds.
They are a great way to capitalize on emerging-market economies that are expected to grow much faster than those in the developed world, said Matt McCall, editor of the ETF Bulletin and president of Penn Financial Group LLC of Ridgewood, N.J.
China is a good example, he said.
For better or worse, however, there are at least four ETFs that provide exposure to China, not counting one that invests in Hong Kong.
Determining which ETF is right for a client can be a challenge, Mr. McCall said. But it is ultimately worth it, he added.
David Hoffman can be reached at [email protected].
