Defending Emerging Market ETFs

Includes: AGEM, EEM, VWO
by: Gary Gordon

When it comes to ETFs, I always feel it is important to return to the basics. Specifically, why on earth should an investor choose an exchange-traded fund over an individual security or a mutual fund?

The primary reasons include (in no particular order): (1) tax-efficiency, (2) trade-ability, (3) transparency, (4) diversification and (5) low cost structure. There are additional reasons… to be sure. Yet when a newfangled ETF fails to meet these 5 criteria, then you may not want to invest in that ETF at all.

I just read an editorial that took a big time swipe at Vanguard Emerging Markets (NYSEARCA:VWO) and iShares Emerging Markets (NYSEARCA:EEM). The heading behind the attack? “Emerging Market ETFs’ Dirty Little Secret.”

In essence, the article slammed VWO and EEM for exposure to economies like South Korea and Taiwan. Are these countries developed or developing? The author claims that unsuspecting investors who believe they are getting pure emerging market exposure are “shocked” by the 27% and 34%, respective, allocations of VWO and EEM to questionable developed/developing markets like South Korea and Taiwan.

(Note: In my estimation, 99% of all investors simply want great returns… and are pretty darn happy with the way VWO and EEM have delivered. I haven’t met anyone who has moped around or cursed out the treacherous powers at Vanguard or Barclays/BlackRock for duping them with investment vehicles that have South Korean or Israeli stocks. What’s more, the highly venerable MSCI Emerging Market Index that both VWO and EEM track, as well as VWO and EEM themselves, are entirely transparent; any investor can see what’s inside at any time. But I digress.)

Now here’s the problem. Like any strong marketing endeavor, a writer will seek to cause doubt in the minds about what you’re holding: VWO/EEM? They’re not the emerging market funds that they’re supposed to be. Of course, the author takes the next marketing step by offering a “pure play solution” for emerging market exposure: the Emerging Global Shares Dow Jones Emerging Markets Composite Titans Index Fund (EEG). What the author doesn’t do, unfortunately, is disclose the financial relationship that his company has with Emerging Global Shares.

Conflict of interest aside, where’s the fair evaluation of EEG? If EEG holds stocks from Egypt and Poland, has Emerging Global deceived us for including frontier market stocks? Is EEG really a better exchange-traded investing tool for emerging markets than VWO or EEM? How do we know?

In my estimation, EEG, VWO, and EEM are equally transparent, as each of these 3 funds can tell you the precise holdings and weightings. And although VWO /EEM are more diversified with 700+ stocks, EEG’s 83 companies are enough for any standard of diversification.

Additionally, one cannot address tax-efficiency at this standpoint, since EEG hasn’t been around for more than a few months. One might be reasonable in assuming that all 3 funds are tax-efficient because they track established indexes that aren’t supposed to change frequently. However, the MSCI Index tracked by both VWO and EEM has been available for 22 years, whereas the Dow Emerging Market Sector Titans Index tracked by EEG has performance data for just 4 years.

The big differences in the funds come down to trade-ability and cost. Let’s start with cost.

Vanguard Emerging Market has a reliable low-cost expense ratio of 0.27%, while iShares MSCI Emerging Market has a higher cost of 0.72%. Emerging Global’s Titans Index Fund has a gross expense ratio of 1.10%, but a current net expense ratio of 0.75% for 1 year “from the date of the prospectus.”

Of course, those are the published costs… but they don’t tell you about hidden costs in the bid/ask spread of trading. Since VWO and EEM are two of the largest ETFs in existence, the bid/ask spread is negligible to non-existent. However, since there are so few assets under Emerging Global Shares management, EEG’s bid/ask spread today was nearly 1.0%! In other words, it may cost you 1% extra to buy and another 1.0% extra to sell EEG… a 2.0% round-trip additional cost, not including the expense ratio!

What’s more, assume you’re a fan of stop-loss protection. If you use a 10% stop for VWO or EEM, you’re almost assured to get out at the price you set. This would not be possible to assure with EEG. With so few shares trading hands, and a 1% differential on the bid/ask spread on a regular trading day, there’s no telling if you’ll even see a stop execute at all.

Heaven help you if you are trying to lower emerging market exposure in a highly volatile trading environ. If you have circumstances similar to those witnessed in late 2008, an ETF without sufficient volume has little chance of finding a buyer at all. A bid-ask spread that may have been 1% might jump to 10%, making it utterly undesirable on the tradeability front.

Stick with exceptionally liquid, highly trade-able, lower cost ETFs like VWO.

Disclosure Statement: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. The company and/or its clients may hold positions in the ETFs, mutual funds and/or index funds mentioned above. The company does not receive compensation from any of the fund providers covered in this feature. Moreover, the commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.