Vanguard’s Benchmark Index Changes To Effect Emerging Markets ETFs

Vanguard has announced it is changing the benchmarks that they track for 22 of their index funds. The affected funds include six Vanguard international stock equity funds, including the corresponding ETFs, which will transit from MSCI indexes to FTSE indexes. Also, 16 US stock funds will change their benchmarks from MSCI indexes to new benchmarks developed by the University of Chicago’s Center for Research in Security Prices (CRSP). In this note, we focus on the change in the widely held Vanguard Emerging Market Stock Index ETF (VWO).

According to Vanguard, the motive for these changes is to “save millions of dollars in licensing expenses for the funds – savings that will benefit shareholders … [and] lower expense ratios over time.” Increasing competition among index and ETF providers is welcome. The expense ratios for Vanguard ETFs already are among the lowest available. Vanguard does not question the quality of the MSCI indexes from which it is transiting. They are the benchmarks used by most professional investors, are available on most data services and analytical platforms, and are based on a sound and transparent methodology. At Cumberland, we will continue to use MSCI indexes to benchmark our international and global ETF portfolios.

In particular, for our Emerging Markets portfolio, the benchmark will continue to be the MSCI Emerging Markets Index, a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index covers the equity markets of the following 21 emerging-market countries: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

We currently are using in our accounts the Vanguard MSCI Emerging Markets ETF, VWO, which, as its name indicates, seeks to track the MSCI index we use as our benchmark. We have preferred this ETF because of its low expense ratio of 0.22%, compared with 0.68% for Blackrock’s iShares MSCI Emerging Markets Index ETF, EEM. VWO also has done a good job in tracking that index. Vanguard says that the transition of its affected funds to new benchmarks will not start for several months and will not be completed until well into 2013. When the process is completed, the VWO ETF will be benchmarked to the FTSE Emerging Index.

There are significant differences between the MSCI and FTSE indexes. The most notable is that the MSCI index includes South Korea with a weight of 15.4%, while the FTSE index excludes South Korea. The FTSE country classification system determined that South Korea should be considered a developed rather than an emerging-market country. We would agree that South Korea is on the margin between the two groupings, but so are Poland, Chile, and Taiwan. Due to this and other differences between the two indexes, their performance has differed over the period both were in existence. As Dave Nadig of IndexUniverse has pointed out, the differences between the two indexes matter. “Since 2003 when the current FTSE version of the emerging markets index was born, the FTSE index is up 193%. The MSCI index is up 180%.” Investors will be able to offset the absence of South Korea in the future VWO by also investing in the iShares MSCI South Korea ETF, EWY. We will need to follow closely the performance of VWO relative to its main competitor, EEM, during and following this transition. As Dave Nadig notes, it is good for investors that the transition will proceed slowly, permitting Vanguard to use the natural creation and redemption process.

The emerging-market equity class is looking more attractive again after underperforming in the 2nd quarter of this year, as it also did in the second half of 2011. Emerging markets as a group advanced by 7.9% in the recently completed 3rd quarter, as compared with 6.8% for the MSCI World equity market index. The Emerging Markets Europe index registered the strongest advance at 9.8%, with Poland up 13.2%. The Emerging Markets Asia index advanced by 8.8%. In that region, India led with an impressive 15.4% increase as investors welcomed a number of market-opening reforms. Taiwan and Thailand both registered 11+% advances, while China’s growth slowdown limited its market’s increase to 4.7%. Latin America underperformed; the Emerging Markets Latin America index was up just 4.7%. The Mexican market led that group with an advance of 6.8%. Brazil’s market saw a 4.8% rise, while the Andean markets (Chile, Peru, and Columbia) increased by just 1.9% due to the depressed price of copper in the first two months of the quarter.

We expect that emerging-market equities as a group will continue to perform well in the current quarter and in 2013. With the reductions in the growth rate of China now appearing to be bottoming out and the improved outlook for India, the Asian emerging markets are likely to regain their position next year as the leading emerging-markets region. At Cumberland we have returned to fully investing our Emerging Market ETF Portfolio accounts, as also is the case for our International and Global Multi-Asset Class ETF Portfolios.

BY Bill Witherell