Buy this, not that: Emerging markets

July 24, 2017 01:41 PM

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One of the big stories of 2017 has been investors deciding that the grass really is greener on the other side. There’s been no bigger winner from this trend than iShares “core” international funds. Intended to offer investors a lower-cost alternative to the first generation of international ETF’s, the massive inflows of new capital have us wondering if investors are going to learn the same hard lesson that scorched so many in the past; that calling something “new and improved” doesn’t necessarily make it so.    

Two of 2017’s biggest asset gatherers— the iShares Core MSCI Emerging Markets ETF (IEMG) launched in 2012 and its older sibling, the venerable iShares MSCI Emerging Markets ETF (EEM) — are a good case to consider. Investors may have found new reasons to love foreign funds, but IEMG is the belle of the ball, pulling in more than $5.4 billion in new assets in the three months ending May 31, while EEM pulled in roughly $1 billion during that period. The surge in money flowing to international funds this year has pushed IEMG’s total assets to within a hair of EEM’s total. Not bad for a four-year old fund.  

Investors’ love for IEMG is easy to understand. At first glance it seems indistinguishable from EEM, the first fund anyone considers when looking for inexpensive emerging market exposure. In fact, beyond IEMG having the word “core” in its name, anyone looking at the literature available on the iShares website or at Morningstar would conclude that the two are almost interchangeable (see “Emerging market brother,” below). EEM is benchmarked to the MSCI EM index, established way back in 1988 when investing in emerging markets was in its infancy, so the index was designed with liquidity in mind. Today it has 23 countries and 85% of the free-float adjusted market cap in each, so funds that benchmark to the MSCI EM index have the biggest and most well-known names and a large-cap feel.  

IEMG is a refinement on that strategy, trying to capture 99% of the market cap, meaning IEMG has literally a thousand more holdings than EEM, and a significantly lower average market cap due to all those smaller names. Still they have similar portfolio holdings, sector and country weightings, but most importantly, comparable performance since IEMG began trading. Not to mention that as part of iShare’s strategy to win over “buy and hold” investors, IEMG’s management fee (0.14%) is a fraction of EEM’s (0.72%).  

What troubles us is that you would think that more smaller stocks mean more volatility, but so far that hasn’t been the case as IEMG has a lower standard deviation than EEM during the last three years while producing slightly better performance than its big brother. If you’re wondering how that’s possible, consider that IEMG’s larger portfolio has the same mega-cap names like Samsung and Tencent as EEM, but IEMG also has a serious number of tiny positions in potentially illiquid headscratchers like the Italian-Thai Development Company (ITD-R) whose market cap is less than $1 million in USD terms and remains thinly traded. But that is the point of indexing, isn’t it: to smooth the volatility of individual stocks. 

Emerging market stocks have come a long way, but as any homeowner can tell you, you only learn the price of an illiquid asset when you try to sell it, and while so far that hasn’t been a problem for holders of IEMG, our colleagues at Morningstar would point out the fund’s annual portfolio turnover is only around 10% compared to 23% for EEM, while the fund also has a relatively wide bid/ask spread and trades far fewer shares on a daily basis compared to EEM. Traders looking to climb on a sure thing might find themselves in trouble if the tides of liquidity start going out.  

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global