All Emerging Market ETFs Are Not The Same

Vanguard made these changes to make the funds more tax friendly and to make them more closely track their respective indices. Before the switch, Vanguard’s sector ETFs and mutual funds tracked traditional MSCI sector indices, which weigh individual companies from their respective sectors based purely on stock market values.

Although this is the most efficient way to ensure that the indices provide the most realistic view of the actual makeup of the market, using them to create ETFs raises red flags with the IRS.

To prevent a fund from becoming too heavily weighted in a small number of holdings, the IRS has implemented a number of diversification rules that ETF and mutual fund providers must comply with in order to qualify for favorable tax treatment. Failure to meet these requirements results in double taxation.
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The importance of keeping tracking error to the minimum is highlighted by Vanguard’s success with its emerging-market ETF.

Over the past few months, investors have been fleeing from the iShares MSCI Emerging Markets Index Fund (EEM) and pouring into the Vanguard Emerging Markets ETF (VWO). These two instruments track the same index: the MSCI Emerging Market Index. At first, one would assume that comparing these funds would be akin to comparing apples to apples. However, if one delves deeper into the inner workings of the two funds, it becomes apparent why investors choose one over the other.

Although each of these funds seeks to track the performance of the same index, each does so differently. The EEM uses a sampling process, leading to the construction of a fund consisting of 439 of the more than 700 constituents in the MSCI Emerging Market Index.

VWO, on the other hand, tracks more than 800 positions, making it even more diverse than the index. By tracking a sampled version of the index, EEM’s performance at times will not always mimic the index.

Year to date through March 3, VWO’s more comprehensive approach to tracking its index has paid off. Not only has the fund seen massive investor inflows, but it has managed to outperform EEM, which is down -2.1% compared with EEM’s 3.3% drop. The MSCI Emerging Market Index is down 2.3% over the same period.

Seeing the success of VWO, it’s no wonder that Vanguard has taken an important step to fix the tracking error issues facing its sector focused instruments while meeting the requirements of the IRS. The funds now track brand new underlying indices.

Rather than tracking the traditional versions of the MSCI indices, Vanguard’s sector funds now track MSCI 25/50 indices, which meet the IRS requirements.