Emerging markets have been going through significant turmoil lately. Volatile commodity prices and economic instability in China are major reasons for concern, and it's hard to tell how the situation will evolve in the coming months. On the other hand, uncertainty usually creates opportunities for bargain-hunting investors, and emerging-market stocks are trading at spectacularly cheap valuation levels.
With this in mind, let's compare the two leading emerging-markets ETFs, Vanguard Emerging Markets (VWO 1.17%) and iShares MSCI Emerging Markets (EEM 1.18%), in order to find out which one is the best choice for investors looking to position their portfolio in conveniently cheap emerging-market stocks.
The trade of a decade?
Emerging-market stocks are generally more volatile than those tied to companies in developed countries. However, investment risk is not just about stand-alone volatility; you need to consider how a particular asset affects your overall portfolio. If your investments are heavily tilted toward the U.S. and other developed countries, adding a healthy dose of emerging markets exposure can do wonders in terms of diversification.
Not only that, there are strong reasons to believe that emerging-market stocks could be offering an amazing opportunity at current prices. Emerging markets have materially underperformed developed countries in the last three years, and they are now trading at a considerable discount when looking at valuation ratios such as price to earnings, price to cash flows, price to sales, and price to book value.
According to Christopher Brightman, chief investment officer at Research Affiliates, weak past performance in emerging-markets stocks bodes well for investors in these markets going forward. In his own words:
Many investors mistake a bear market for diminished prospective returns. From the rearview mirror, the bear market in emerging markets has been painful. When we look out of the windshield, however, these very asset classes offer the highest potential returns available to today's opportunistic investor. So, the exodus from emerging markets is a wonderful opportunity -- and quite possibly the trade of a decade -- for the long-term investor.
The best emerging-market ETF
Vanguard Emerging Markets and iShares MSCI Emerging Markets are the most popular ETFs to invest in large companies in emerging markets. The two instruments offer fairly similar portfolios, although there are some relevant differences to consider.
Vanguard Emerging Markets is in the process of adding Chinese A-shares to the portfolio during 2016, while iShares MSCI Emerging Markets will continue to exclude those companies. A-shares are the local shares of Chinese companies trading in Shanghai and Shenzhen. Foreign investors face serious regulatory limitations in terms of their ability to buy Chinese A-shares directly, so gaining some exposure to these companies via ETFs could be a smart way to circumvent those regulations.
On the other hand, iShares MSCI Emerging Markets includes Chinese companies listed in the U.S., such as Baidu, Sina, and Alibaba, while those names are excluded from the Vanguard vehicle. Similarly, iShares MSCI Emerging Markets considers South Korea an emerging market, but that's not the case when it comes to Vanguard Emerging Markets, since FTSE indexes classify South Korea as a developed country.
Nevertheless, the difference in overall portfolio construction is not too big, and both ETFs have delivered almost identical returns over the last five years. Investors would be hard-pressed to pick one fund over the other based on their portfolio methodologies and track records.
On the other hand, the Vanguard product has a considerable advantage over the iShares ETF in terms of cost. Vanguard Emerging Markets charges a conveniently low annual expense ratio of 0.15% -- that's 90% lower than the average expense ratio of funds with similar holdings, according to Vanguard. By comparison iShares MSCI Emerging Markets has a much higher annual expense ratio of 0.7%.
Returns accumulate over time. While a 0.55-percentage-point spread in annual costs can sound like an irrelevant difference over the short term, it can have a considerable impact on investment returns through the years and decades. Because of this major cost advantage, Vanguard Emerging Markets looks like the best ETF for investors looking to capitalize on the opportunity to invest in emerging-market stocks at attractively cheap valuation levels.