Emerging Market ETFs: Is There a 'Best' Choice?

Recently, some members of the investment business have suggested that emerging markets offer unusually good value. This, of course, offers me another opportunity to explore one of my favorite topics.

According to one recent article, despite the growth of emerging markets, which currently represents 13% of the world stock market capitalization, British investors have only 1.6% of assets in those markets. Presumably, American and Canadian investors are in the same boat. This is even more alarming given that these markets are widely forecast to achieve 50% of the world economy in 20-30 years time. That means that most investors aren't playing the largest visible theme of our times.

Given the growth in ETFs and mutual funds catering to this segment, there's no excuse for most stock investors with a 10-15 time horizon not to be in this market. This is a growth component, which can’t be ignored.

Having said that, I'd like to take a look at two of the most popular emerging market ETFs and their market-capitalization choices. I will also look three ETF choices from purveyors who use a rules-based fundamental analysis to choose an emerging market basket.

The first two are choices from Barclay's iShares (EEM) and Vanguard (VWO). They are based on selecting and tracking broad-based market-capitalization based indexes. Market capitalization indexes (such as the S&P 500, MSCI EAFE, etc.) select the largest companies by market capitalization for inclusion into the index.

Critics argue that these types of indexes over represent over-valued companies, and under represent undervalued companies, and investors therefore leave some potential alpha on the table, while attracting unwanted volatility. On the other hand, supporters of these indexes argue that, despite these flaws, owning such an index proxy is still a reasonable way to participate in most of the stock markets gains, in a tax and cost efficient manner.

Let's take a look under the hood of both of these choices:

First, let's look at cost and turnover. On cost, Vanguard has its legendary cost structure sliced to the bone, with just a 0.25% cost, while the Barclay's product EEM has a 0.74% cost. A 0.49% point advantage isn't to be sniffed at, but it’s not the only item of consideration. Turnover for VWO is 9% annually, the second highest rate amongst the five products we'll look at. The iShares EEM has a turnover of just 5% annually. In a non tax-deferred account, these two cost and turnover factors are offsetting, with no clear winner. In a tax-deferred account, the VWO is the better choice, if these were the only two factors under consideration.

Second, let's look at the average company size and country choices of some of the top sectors in each product. In terms of average company size, both are similar with Morningstar defining between 77-80% of the companies held therein as large or giant, and between 18-22% as mid-size. That means either fund has virtually no exposure to small cap stocks, or both can be thought of as large cap ETFs.

In terms of the top four sector allocations, both have financial firms (banks etc.) at between 18-22% of the fund, energy at between 16-20%, and materials between 18-21%. The only difference is for the fourth choice, which for iShares EEM is information technology at 14%, while for Vanguard VWO it is telecommunications at 12%.

In terms of individual stock concentration, the top four choices of EEM comprise some 16.2% of the portfolio value, while for VWO it is 12.2%. The top 20 choices comprise some 40% of the value of EEM, while for VWO it is 27%. EEM holds about 350 securities in total, while it's nearly 900 for VWO.

On these three later factors of market size, sector choice and stock concentration, there isn't that much to choose between these. So let's turn to country selection.

In both ETFs, the top four countries represented in these ETFs are similar, with Brazil in first place representing 16-18%, and either China or South Korea in second or third place between 11-13%. The difference is in fourth place, where Russia represent 11% of EEM, while fourth is held by Taiwan in VWO, again with 11%. Overall, once again, there is very little to choose from between the two.

Finally, we turn to relative value measures of the portfolio. However, I have to complain about "the people's choice," Vanguard, long a champion of the individual investor. Their disclosure of valuation of the portfolio, in a word, sucks! The only valuation measure they offer is price-to-book [P/B] ratio, wherein all of the other choices we'll look at provide at least the price-earnings [P/E] ratio and the dividend yield of the portfolio, with some others also providing the price-to-sales [P/S] ratio.

Having said that, the P/B ratio of VWO is 2.8, compared to 3.7 for EEM. Morningstar calculates the dividend yield at 2.22% for VWO and 2.70% for EEM. Combining these two measures of relative valuation, suggest these portfolios offer relatively similar attractiveness from a valuation standpoint.

Yahoo calculates the P/E of EEM at 11.9 (versus iShares own calculation at 18.0), and VWO at 13.0. Given the differences in PE calculations I've seen between Yahoo and ETF providers themselves, I don't think the Yahoo (YHOO) calculations are particularly reliable. On the other hand, Morningstar calculates the cash-flow ratio of both portfolios to be between 8.5 (EEM) to 8.9 (VWO). Therefore, there's little to choose from here, except to say that both portfolios appear relatively expensive, given the valuation characteristics of the three other product choices that I'll cover in a future posting later this week.

In addition, although no one looks at historical charts - given that we're all aware that past performance is no guarantee of future performance, let's see how the two products have performed against each other and the S&P 500 ETF (SPY) over the past year.

click to enlarge

Given the similarity between the products, I'd say it's hard to pick a clear winner. Perhaps if Vanguard would get into the modern era, and provide its investors better information, as well as its outstanding cost structure, it would be easier to make a choice between these two.

Disclosure: No positions held.

Comments

[Jason Zirotti:]

Jay, I currently hold a position in VWO. As you think that neither VWO or EEM offer compelling advantages over the other, are there other Emerging Market ETFs that offer a better solution in a casual investor's long-term portfolio?

2008 Aug 05 09:40 AM

[Jay Walker:]

Hi Jason,

Yes, there's a few better choices in my opinion. Visit my site for a full discussion of those choices.

2008 Aug 09 05:42 PM