Causes Of Performance Differences

Tracking error can be caused by many things, and in areas like emerging markets, more error can be expected because of the challenge in tracking the index where stocks may be illiquid and hard to invest in.

Expense ratios do directly affect an ETF's ability to track its index, as do trading costs. The index does not recognize these costs, so tracking error will never be perfect.

In comparing these two ETFs, there is a significant difference between expense ratios. Currently EEM charges 72 basis points and VWO has an amazingly low 27 basis point expense ratio.

But as the table below shows, there is apparently more to tracking error than the expense ratios would lead us to believe. This table compares the NAV returns of VWO and EEM with the annual returns of the MSCI Emerging Markets Index. It showcases why tracking error is an important component of investing in an ETF. If an ETF issuer can manage tracking error better than its peers, costs still matter, but will matter less.

In this example, using larger time frames than the monthly returns studied above, the Vanguard product seems to generally do a better job of tracking its benchmark.

One critical factor that impacts tracking error is how the manager tries to replicate the return of the index. Neither Vanguard nor iShares simply buys the full locally listed holdings of the MSCI Emerging Market Index.

Managers from both ETFs use ADRs to help better replicate the performance of the index. The benefit of using ADRs is firstly to reduce the cost of investing in foreign markets, and secondly to allow the underlying holdings to trade during the same hours as the ETF for more-efficient creations and redemptions.

According to Vanguard, VWO currently uses ADRs to represent 15% of the NAV of the ETF, while iShares uses 55% of ADRs in EEM. Vanguard does overlap some of its holdings using ADRs as well as local shares of a company, which explains why VWO currently has more holdings at 788, compared to its index, the MSCI Emerging Market Index, at 731 holdings.

In comparison, iShares EEM holds only 342 underlying stocks, just 46% of the index's holdings. It appears as though Barclays has optimized its fund to include only the most liquid and largest emerging market companies included in the index, taking advantage of ADRs on the market. This has made the average market cap much higher relative to the MSCI Emerging Market Index.

Optimization can also impact country-specific exposure in the fund versus the index, as well as other factors. Sampling or optimizing an index added value in this case, and the use of careful sampling may make sense in the case of emerging markets, of course. But it is not without risk.

Looking at the last quarter of 2008 through 3/25/2009, we can see the difference iShares' sampling of the index's holdings had on relative performance to the index and overall return. Figure 2 reviews NAV returns for the funds against their benchmark over the past year.

Figure 2.

While no one would ever complain about outperformance, it is important to note the EEM's objective is not to beat any index, but to track it as closely as possible. The fund's managers should optimize to better meet this goal. Vanguard's VWO, over the time period graphed, did a much better job of staying close to the index.

In the long run, both ETFs face challenges in tracking the emerging market index.

The management through optimization of an ETF will affect the way the ETF will track the index. Cost and optimization matter. However, the more optimization an ETF has, the more risk there is for that fund to not track the index in the future. Still, a fund diversified across the same sectors that can closely match the stocks, sectors and currencies that drive index return can reduce cost, while excluding those companies too illiquid or problematic to allow efficient creations and redemptions can benefit ETF index investors. It's a fine balance to be made.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

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