(Dow Jones) Individual investors are often told that index-linked funds are better for them than actively managed offerings. That may be true, but index funds carry their own risks that can catch the unsuspecting.
Look, for example, at two exchange-traded funds that track the same international-stock index-and yet their results last year are significantly different.
IShares MSCI Emerging Markets Index ETF (EEM) and Vanguard Emerging Markets ETF (VWO) both track the MSCI Emerging Markets Index. But the Vanguard ETF gained just over 76% last year, while the iShares offering was up nearly 72%. The Index itself was up 78.5%.
The difference highlights the varied results index funds can produce and offers a lesson to investors about the best way to choose an indexed investment.
How can investors tell which ETF best tracks its benchmark index and also come to realize that not all indexes are the same? The answer isn't so straightforward.
This isn't a case of which ETF sponsor is in the right. In good years, the Vanguard fund will outperform, but when the index has a bad year, as in 2008, the iShares fund, holding only about half the stocks in the index, has in theory a better chance of outperforming. In 2008, the Vanguard fund was down almost 53% while the iShares fund fell about 50%.
Not So Simple
"ETFs are a simple investing vehicle, but they're not simple investments," said Scott Burns, director of ETF analysis at investment researcher Morningstar Inc. "There's nothing simple when it comes to investing."
There are two main reasons why the iShares and Vanguard funds delivered such different results. The first is that the Vanguard ETF charges much lower fees than the iShares fund: 0.27% of assets compared to 0.72%. That savings is passed directly to the investor and boosts returns.
It's also about how the funds are constructed. The Vanguard fund tries to fully replicate the index, sometimes holding more than 800 stocks. The iShares fund is more selective, typically holding just over 400 stocks. The reason for this is that the two funds are doing two different things.
When an order is placed for, say, 50,000 shares of the iShares ETF, iShares takes in-kind payment of the underlying securities that it believes can best replicate the MSCI index. IShares chooses to limit the stocks it uses to create the fund in the interests of liquidity.
Vanguard's ETF is actually one share class of its Emerging Markets Index Fund, and it can trade for the stocks with its mutual fund sibling, the $30.5 billion Vanguard Emerging Markets Stock Index Fund (VEIEX), which provides liquidity should the firm's ETF need it.
"Their ETF has a great, big, huge trading partner, which is their mutual fund," said Burns.
As a result, Vanguard's ETF has much less tracking error than the iShares fund--in other words, it follows the index more closely.
Fran Kinniry, head of the investment strategy group at Vanguard, said that difference isn't seen just with emerging markets ETFs: Vanguard Total Bond Market ETF (BND) also has a similar advantage over its rivals, he said.
Dina Ting, portfolio manager at iShares, a unit of BlackRock Inc. (BLK), who oversees the iShares ETF, said iShares approach "maximizes liquidity and tax-efficiency" for investors, and pointed out that the iShares fund is traded much more heavily than the Vanguard fund.
It's down to each investor to decide which way to go. But if tracking error is a concern, the best way to judge a fund is to compare its returns to the index over several different periods, Burns said.
Confusion for investors doesn't end with different ways of replicating an index. Investors who want to own an index-tracking fund for a small slice of the market are also stepping into potential trouble.
For instance, those who want a small-cap growth ETF have three main choices: iShares S&P SmallCap 600 Growth (IJR), SPDR Dow Jones Wilshire Small Cap Growth (DSG) and Vanguard Small-Cap Growth (VBK).
Over the past year, returns have been 38% for the iShares ETF, and 56% and 52% for the SPDR and Vanguard ETFs, respectively--a large difference over one year for funds that theoretically are tracking the same slice of the stock market.
Unlike the emerging markets ETFs, these funds don't follow the same index. But the differences between the three different indexes that apparently cover the same part of the stock market can be bewildering.
"What those three indexes say is small-cap is different, and what they all think of as growth stocks is different," said Burns.
So what's best? That depends on what you're looking for. For broad and more liquid sectors, such as U.S. large-caps, there isn't much difference between indexes. But for narrower slices of the market, the benchmarks become increasingly important.
Bradley Kay, Morningstar's associate director for European ETF research, highlighted some basic differences between the leading index providers. He said MSCI and FTSE were the purest when it comes to covering their markets, while Dow Jones' broad market indexes skew toward larger companies. Standard & Poor's chooses its indexes by committee and also requires, with a few exceptions, four quarters of profitability, Kay said.
There are also different types of indexes. A market capitalization-weighted index, for instance, is typically less volatile, while a fundamentally based index will likely tilt towards value stocks. Meanwhile, an equal-weighted index is likely to have more smaller-cap and midcap stocks.
Without a lot of digging, it's hard to know which approach an index provider follows and to gain a real understanding of each indexer's characteristics.
Vanguard, for one, pegs most of its ETFs to MSCI indexes. "We think MSCI is better at rebalancing and their indexes are more fluid and real-time," Kinniry said. "They provide the best point-in-time exposure."
If MSCI doesn't run to your taste, that's not a problem so long as you know what you're getting.
"It's very important to understand the index you're buying and which benchmark you really want to track," Kinniry noted.
Burns added that mixing between indexes isn't a good idea. If you buy an S&P large-cap index, it's best to stick with S&P indexes for other cap sizes because switching to, say, an MSCI index could lead to holes in your portfolio -- you could miss entire companies.
And as with all aspects of investing, it's important to remember how expenses affect performance. Every bit saved in fees stays in your pocket.
Burns said the cheapest broad-based ETFs today are the funds offered by Charles Schwab Corp. (SCHW). Schwab has eight ETFs, all but one of which, according to its Web site, are cheaper or as cheap as the cheapest comparable ETFs from Vanguard, iShares or State Street Global Advisors, a unit of State Street Corp. (STT).
Among sector-focused ETFs, Burns said the Select Sector SPDR lineup of ETFs is cheapest. The average expense ratio for these nine ETFs is 0.21% of assets. In areas where neither Schwab nor Select Sector SPDRs have offerings, Burns added, Vanguard ETFs are typically the cheapest.
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