Exchange traded funds (ETFs) were designed to shadow the performance of the index they track. However, some do a better job of this than others. As an illustration, let’s look at two different ETFs that both cover emerging markets: iShares MSCI Emerging Markets Index (EEM) and Vanguard Emerging Markets Stock ETF (VWO). Currently, EEM is up 34.8% year-to-date, and VWO is up 39.3% year-to-date.
During the volatile month of August, EEM held up relatively well. When the benchmark index was down 2.1%, EEM was down 0.6%. However, its three-year annual return of 37.2% trailed the index by about 1.3 percentage points, reports Lawrence C. Strauss for Barron’s. In comparison, VWO has a one-year return of 44.1% as of Aug. 31, beating the index by almost half a percentage point. So what accounts for the index tracking disparity between the two ETFs?
One of the reasons lies in the number of holdings. VWO has about 850 holdings where EEM has about 550. The index holds about 840 securities. Both ETFs are optimized, which means they use fewer holdings to approximate the index. This helps give the ETFs lower transaction costs and fewer embedded tax gains. Another difference between the ETFs is that EEM has more in assets ($18 billion), so its transaction costs are generally less than VWO’s. Vanguard’s ETF has $4.4 billion in assets. However, VWO’s expense ratio is 0.30%, which is much less expensive than EEM’s at 0.75%.
For full disclosure, some of Tom Lydon’s clients own EEM.
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