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By Patricia Oey

Investors have poured $38 billion into Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO) over the past three years, making it the third-largest exchange-traded fund on the market. It is also the largest fund of any sort focusing on broad emerging-markets exposure, thanks to its very attractive price of 0.20%.

In early October, Vanguard announced that it is changing the fund's benchmark from the MSCI Emerging Markets Index to the FTSE Emerging Index, and the most significant difference between the indexes is that South Korean equities (which currently account for 15% of the fund) are not part of the FTSE Index. While investors may be concerned about the significance of this change, we think there is a more relevant question investors should be asking themselves--is a cap-weighted fund the best way to passively invest in the emerging markets?

More Than Just a Korea Conundrum
South Korean equities have a cyclical orientation, given their heavy exposure to tech (such as Samsung Electronics), consumer discretionary (such as Hyundai and Kia), and industrial firms (such as shipbuilders), many of which are major exporters to both the emerging and developed world. That said, since the FTSE Emerging Index and the MSCI Emerging Markets Index are both cap-weighted, the indexes are very similar (with the exception of South Korean equities), and the correlation in performance over the past three years has been nearly 100% (FTSE moved South Korea out of its Emerging Index in September 2009). So, for those considering moving out of VWO into a product that tracks the MSCI index, such as iShares MSCI Emerging Markets Index (NYSEARCA:EEM) or its new low-priced (0.18%), all-cap sibling iShares Core MSCI Emerging Markets (NYSEARCA:IEMG), we would say this is not necessary.

For investors willing to step away from traditional indexing methods, we suggest considering non-cap-weighted exposure to emerging markets. Many emerging-markets countries practice some form of state capitalism, and as a result, large caps tend to be government-owned entities (such as Brazil's Petrobras and Russia's Gazprom), which may place economic or political goals ahead of shareholder interests. Large caps can also be bloated organizations (such as India's Reliance Industries) whose historically protected status may be ebbing away. We also note that cap-weighted funds have low exposure to entrepreneurial companies, which tend to be smaller in size but have greater exposure to market trends such as rising consumption levels.

Informational Advantage of Dividends
We think dividend ETFs provide a more attractive exposure to emerging markets. One of the most obvious reasons for this is that dividends are clearly measurable, which is even more important in emerging markets, where accounting practices are less transparent. Dividend-oriented funds tend to have higher-quality portfolios and over the past few years have provided better risk-adjusted returns, relative to a cap-weighted exposure. Dividend funds have a heavy weighting in Taiwan (around 20%), where tax rules are very dividend-friendly. (Shareholders are allowed to offset individual income tax liabilities with corporate taxes paid on dividends received, and corporates are charged an extra tax on retained earnings.) At this time, China is Taiwan's largest trading partner, and the two are continuing to liberalize certain trade and investment restrictions--this means that an investment in Taiwanese companies provides exposure to China's growth and perhaps is a better alternative than investing in Chinese large caps.

We have long been fans of WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM), which tracks a dividends-paid-weighted index. Over the past five years, DEM's annualized returns (to Sept. 30, 2012) of 4.0% handily beat the MSCI's negative 3.2% with significantly lower volatility, earning the fund a Morningstar Rating of 5 stars. This ETF's 12-month yield is 3.7%, and its fee is 0.63%. Another option is SPDR S&P Emerging Markets Dividend (NYSEARCA:EDIV), which tracks an index whose constituents are screened for earnings quality and liquidity and are weighted by dividend yield. Despite this ETF's high-yield focus and mid-cap tilt, its volatility has been in line with that of the MSCI index over the past five years and has generated five-year annualized returns of 1.9%. EDIV's 12-month yield is more than 6%, and its expense ratio is 0.59%. Investors may want to hold dividend-focused funds in tax-deferred accounts, especially if dividends will be taxed at ordinary income rates next year. That said, these funds pay out dividends net of foreign tax withholding--investors can claim a tax credit but only if the fund is held in a taxable account.

Another "fundamental" approach to passive emerging-markets investing that we like is a minimum-volatility product such as iShares MSCI Emerging Market Minimum Volatility Index (NYSEARCA:EEMV). EEMV holds a portfolio of stocks culled from the MSCI EM Index that has the lowest absolute volatility with a given set of constraints to maintain country and sector diversification and typically results in a bias toward stocks with low idiosyncratic risks. Over the past 10 years, this minimum-volatility index has provided an average 400 basis points a year of excess return relative to its parent index, on much lower volatility, even with its mid-cap tilt. And consistent with our view that dividends are a good indicator for quality in emerging markets, this ETF's index's yield of 3.6% is 70 basis points higher than that of the parent index. Interestingly, while this ETF has similar overweightings in Taiwan and telecoms like dividend ETFs (which tend to have a value tilt), this ETF has a growth tilt and not much overlap with dividend-focused funds. As such, investors can consider holding both EEMV and a dividend ETF.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: VWO: Should I Stay Or Should I Go?