Five Critical Differences Between EEM And VWO

by on February 17, 2010 | ETFs Mentioned:

Emerging markets have been one of the hottest investment trends in recent years, as U.S. investors have begun to question assumptions about the relative risk profiles of advanced and developing economies in the wake of the recent global recession. Government intervention, a risk usually associated with emerging economies, has become common practice in the U.S. and Europe, and China and Brazil have raced ahead of developed markets struggling to achieve sustainable GDP growth.

The iShares Emerging Markets Index Fund (EEM) and Vanguard Emerging Markets ETF (VWO) have seen huge cash inflows over the last year, becoming two of the largest equity ETFs in terms of total assets. Both these products seek to replicate the MSCI Emerging Markets Index, leading many investors to believe that they are identical. A look under the hood of these products, however, reveals five areas in which they are not nearly as similar as they first appear.

5. Expense Ratio

One of the first metrics many investors consider when comparing two comparable ETF investments is the expense ratios charged by the funds. Generally, fees for funds tracking a similar (or identical) index should be relatively close, but that’s not always the case. Like most Vanguard funds, VWO offers one of the lowest expense ratios in its ETFdb Category, just 0.27%. EEM, on the other hand, charges 0.72%, one of the highest. The 45 basis point gap can translate into a material difference in bottom line returns, especially for buy-and-hold investors.

4. Depth Of Holdings

Given that EEM and VWO seek to replicate returns on the same index, the underlying holdings of the funds are surprisingly different. EEM consists of about 440 individual securities (about 57% of the MSCI Emerging Markets Index) while VWO holds 810 stocks, more than the number in the underlying benchmark.

Even within the common holdings of these funds, there are some big gaps in allocations. Gazprom OAO is VWO’s largest component, but seven stocks receive a larger allocation in EEM. VWO’s top ten holdings account for about 14.5% of total assets, compared to 22.4% for EEM.

3. Tracking Error

Many investors mistakenly assume that ETFs will always closely approximate the return on the underlying benchmark. For funds that use a full replication strategy, such as VWO, this is generally true. But ETFs that use a sampling technique to replicate index performance, such as EEM, may be vulnerable to tracking error.

According to the tracking error tool on the iShares Web site (a great resource for any ETF investor), EEM returned 71.9% in 2009, while the MSCI Emerging Markets Index returned 78.5%. That’s more than 650 basis points in tracking error–a major red flag for investors.  VWO has also exhibited some tracking error historically, but given the (more than) full replication technique it employs the gap has been only about 50 basis points annually since inception.

2. Country Exposure

Country EEM VWO
Brazil 14.0% 16.1%
India 6.3% 7.7%
South Africa 8.0% 6.9%
Source: Issuer Web sites

In addition to gaps in the individual components of these two funds, there are some material differences in the country exposure offered by EEM and VWO. The BRIC bloc of countries (including Hong Kong) accounts for 43.8% of EEM and 48.3% of VWO, a significant disconnect for two funds tracking the same index. VWO gives a higher allocation to Brazil and India, while EEM gives a bigger weighting to South Africa.

1. Liquidity Of Options Markets

Considering that VWO seems to have numerous advantages–most notably cost and tracking error–over EEM, the amount of assets accumulated the two otherwise identical funds is perhaps a bit perplexing. At the end of January, EEM had $35.5 billion in assets (making it the third-largest U.S.-listed ETF behind only SPY and GLD), while VWO had a relatively small $19.1 billion.

So why has the emerging markets ETF with the highest expense ratio and largest tracking error become so popular? One reason may be the relative liquidity of the options markets for these funds. For investors who use various options-based investment strategies–such as covered calls–the bid-ask spread of the options contracts can have a major impact on bottom line return. A quick look at the options volumes for EEM and VWO shows a huge gap in trading volumes–options on EEM generally offer a very narrow bid/ask spread, while contracts on VWO can be far less liquid.

The Verdict

For buy-and-hold investors utilizing plain vanilla strategies, VWO is superior to EEM in almost every way–lower expenses, lower tracking error, and better diversification. But EEM does offer significant advantages for some traders, most notably those who utilize options in an attempt to enhance returns or limit risk and depend on the ability to trade such contracts at or near their net asset value.

It should be noted that EEM and VWO aren’t the only ETFs for investors looking to gain emerging markets exposure–see Beyond EEM: Alternative Emerging Market ETF Options for more investment ideas.

Disclosure: No positions at time of writing.