The WSJ and Investors Get it Partially Right on Vanguard’s Emerging Markets ETF

The WSJ reported on a topic that has been revolving in professional circles for quite awhile. Vanguard will be changing benchmarks for its emerging markets ETF (ticker VWO)going from MSCI to FTSE as its index benchmark. The most important impact, as the article notes is that South Korea will no longer be in the Vanguard ETF:

As a consequence investors have been pulling large amounts out of the Vanguard ETF, the article reports $900 million in outflows in the past month .

Looking at performance over the last 3 years, it is not hard to see the reason for investors desire to retain investments in South Korea. 

3 year performance 

 VWO  Vanguard Emerging Markets (which still includes South Korea), 13.2%

 SCHE  Schwab Emerging Markets ETF (which is based on the MSCI emerging markets index which 

excludes South Korea) 6.8%

 South Korea country index EWY .33.4%

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But investors and the WSJ may have jumped the gun. A strong argument can be made to retain the South Korean exposure but the change will not occur overnight and has not yet begun. Below is the performance of Vanguar

The transition at Vanguard will be done gradually over six months beginning in January, so arguably even those that want to retain South Korea as part of their emerging market holdings might have rushed to the exits too soon. The prospective change has not yet had an imapct on performance.

As can be seen below VWO the Vanguard ETF has had nearly identical performance to EEM the ishares ETF that has no plans to switch away from the MSCI index which includes South Korea.   During the period of those $900 million outflows (since November 1) Both VWO and EEM have outperformed Schwab’s emerging markets ETF SCHE which already uses the FTSE index which excludes South Korea. 

Performance is shown as growth of $100,000 VWO blue, EEM green, SCHE yellow) click to enlarge

What is the best  way for investors to proceed:

•    They could switch before January from VWO to EEM. Based on inflows into EEM it seems that some investors are doing exactly that. EEM does however have relatively high management fees of .67%.  Investors might want to consider  the newer lower fee ishares emerging markets ETF IEMG (.18% management fee) which both include South Korea.
• They could retain the low fee VWO and add holdings of EWY the South Korea ETF.

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Some have expressed the view that in response to the VWO rebalancing  South Korean stocks may have a selloff that creates along term  buying opportunity in the South Korean market. Two ways to implement a timing strategy for buying South Korea would be:

Selling VWO  and investing  the proceeds into SCHE the Schwab ETF which  is based on the FTSE (non South Korea inclusive) index.

After a selloff of South Korean stocks sell the SCHE and then buy one of the ETFs that includes South Korea (EEM or IEMG)....or retain the SCHE position and add a country position in EWY (South Korea)

Or:

Hold the VWO position but add a position in the South Korea ETF (symbol EWY) either now, at some point during the transition process or at the time of a possible selloff.

Of course the latter move may just be too esoteric for many investors.

But as the number shows there is a good reason to make portfolio adjustments in the near future in response to the changes in VWOs indexing methodology.

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While on the topic of emerging market investing it is worth making note of the relatively new minimum volatitlity emerging markets index which not only has a significant holding in South Korea 10.45% but also has a different mix of companies compared to other emerging market indices thus giving more diversification in emerging market holdings. While EEMV has only been in existence since October 2011 it's track record is impressive (eem vs eemv below returns top volatility below). 

The minimum volatility strategy has become available across for both US and international markets and there is a significant amount of research supporting that approach.