Can iShares Stem the Flow of Assets From EEM to Vanguard's VWO?

| About: iShares MSCI (EEM)
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By Matt Hougan

The trickle of assets moving from EEM to VWO has become a flood. How long can iShares hold out?

The iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) and Vanguard Emerging Markets ETF (NYSEARCA:VWO) are rare birds in the U.S. ETF industry, in that they track the exact same index. There are a few other duplicative products in the ETF world—the S&P 500 SPDRS (NYSEARCA:SPY) and iShares S&P 500 ETF (NYSEARCA:IVV), for instance—but for the most part, ETF companies have steered clear of direct, mano-a-mano competition.

But since 2006, it’s been exactly that for EEM and VWO.

According to some, it hasn’t been a fair fight. The biggest issue is expenses: VWO charges just 0.27 percent in annual fees, while EEM charges 0.72 percent. EEM also has a significantly larger tracking error, as we reported as early as 2007 and again in 2009.

Partially as a result of these differences, investor fund flows have favored VWO. Since we first reported on EEM’s tracking error in September 2007, its assets have gone from $18.2 billion to $36.6 billion, driven by $14.8 billion in net cash inflows. VWO’s assets have risen over the same time frame from $4.3 billion to $24.6 billion, an increase of 469 percent, driven by $18.2 billion in cash flows.

The trend has accelerated. In the first quarter of the year, as Dave Nadig reported in his recent ETF fund flows review, EEM has had $4.4 billion in net outflows, while VWO has enjoyed more than $8 billion in net inflows. That’s a mammoth swing in just three months.

In the past, iShares has argued that EEM plays to a different audience than VWO, capturing institutional investors rather than the retail crowd. It has argued that relative fund flows are time-sensitive, with institutional investors often buying into markets earlier than the retail crowd. If that’s true, maybe retail investors should be following the “smart” money out of emerging markets right now.

But as VWO has grown, its appeal is probably growing with institutions. The big knock against VWO was that it wasn’t as liquid as EEM. But VWO’s liquidity is increasing. While EEM still has much higher volume—it trades about 73 million shares per day—VWO is catching up, with not-too-shabby average daily volume of 12 million shares per day. That’s getting to be pretty liquid.

Could iShares reverse this trend?

I’m not sure.

If iShares really wanted to chip into these fund flows, they would need to drive EEM’s price tag down substantially—say, from 0.72 percent to 0.50 percent or lower. But that cut, which would still leave a big gap in expenses, would shave $73 million off of iShares’ revenue line. That would be a hard pill to swallow.

In the end, the company may be better off focusing on that liquidity advantage and doing everything it can to further improve that liquidity, working with market makers, supporting the options market, etc.

If the outflows continue, iShares may have to consider more painful measures to compete.

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