They say imitation is the sincerest form of flattery.

One of this year’s big ETF stories was the Vanguard MSCI Emerging Markets ETF (NYSEArca: VWO) eclipsing the iShares MSCI Markets Index Fund (NYSEArca: EEM) as the world’s biggest developing-country ETF. However, iShares is working to catch up and, by the looks of it, might be borrowing a page from Vanguard as it retools EEM.

As part of a strategy shift that dates from early 2010, iShares has nearly doubled the number of securities in EEM’s portfolio. It’s abandoning what is known as a "representative optimization investment strategy," under which it attempted to track EEM’s index without owning all the securities in it.

In place of the so-called sampling strategy appears to be a full replication strategy involving owning most, if not all, of the securities in the MSCI Emerging Market Index—precisely what Vanguard has been doing with VWO from the first.

So is San Francisco-based iShares, a unit of BlackRock, really following Valley Forge, Pa.-based Vanguard’s example?

“We do not follow a strict definition of replication,” Paul Lohrey, managing director and head of iShares U.S. product management, said in a telephone interview, “but as suggested by a comparison, the number of holdings in the portfolio relative to the number of stocks in the index is pretty close.”

The implications of the shift are significant, as the full replication strategy Vanguard has employed on VWO since its launch in 2005 is one of the reasons its fund has had better returns than EEM. But that performance gap has been bridged over the past 18 months, as IndexUniverse ETF Analyst Carolyn Hill wrote about in a recent blog titled “Is EEM Back?”

That improved performance may be one of the reasons the iShares fund has been gathering assets about as quickly as VWO in the past few months. As of Nov. 15, VWO was a $44.88 billion fund and EEM had $34.21 billion in assets, according to data compiled by IndexUniverse. VWO, which came to market about two years later than EEM, in March 2005, became the bigger of the two funds on Jan. 18.

Two Years In The Making

EEM’s move toward a fuller replication strategy dates from February 2010, when the fund only had 489 stocks in its portfolio, according to data from the Connecticut-based company Factset. By comparison, VWO held 866 stocks in its portfolio at that time. A month later, in March 2010, EEM’s total holdings in its portfolio had jumped to 622 stocks.

Today EEM actually has more securities than are listed on the MSCI Emerging Markets Index, likely the result of owning different classes of the same securities, including American depositary receipts (ADRs) and global depositary receipts (GDRs). The index currently comprises 819 stocks. According to iShares’ website, EEM currently has 855 stocks. Vanguard’s VWO also has increased its holdings, to 914 stocks.

One of the big motivating factors for EEM’s move toward a full replication strategy was expand its appeal, Lohrey said.

“If you look at the history of the fund going back to 2003, it was managed to help facilitate liquidity in the product,” Lohrey said. “That has made it very popular among institutions, especially those who value deep liquidity and use the product as a hedging vehicle.”

However, Lohrey says that in recent years, EEM has attracted more strategic and longer-term holders who “probably have more sensitivity to tracking error than a shorter-term holder.” The change in investment strategy is part of an effort to try to please both the hedgers as well as the longer-term clients, says Lohrey, noting that the fund is working hard to improve its tracking record.

“We’ve repositioned the portfolio to track better and monitored its trading activity to make sure it remained highly liquid,” Lohrey said. “I am happy to say it has, based on what we see in terms of spreads, trading volume and market depth.”

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