Friday, 5 October 2012

Vanguard Index Change and Navigating The ETF Maze for Global Equities

This past week, Vanguard announced that it was changing its index provider from MSCI to FTSE on several of its ETFs that hold equities of many countries around the world. The investor might ask, "So what, why should I care?" Here are a few reasons, apart from the fact that Vanguard is a leviathan in the ETF world and is a popular option for passive index investors seeking US and global equity funds:

1) Potential MER reductions
Vanguard's announcement expressly states that its intent is to lower Management Expense Ratios by passing along the benefits of a better deal on the costs to license the use of the index that the ETFs track. Though Vanguard doesn't say, Canadian Couch Potato's post reviewing the change guesses the license fees might be 10-15% of fund costs. The change comes on the heels of ETF competitor Schwab's announcement lowering fees (see the IndexUniverse article here) on its ETFs. Hopefully the top ETF provider iShares' owner BlackRock will be making reductions as well - see a reference to the possibility in this Reuters news item. MER price competition is good for investors since fee reductions go right to the bottom line as higher returns. When MERs are down to 0.2% or less per year, as they are with many of the lowest fee ETFs, reductions may seem small but they still have an appreciable impact over the long term.

2) Changes in portfolio and likely future performance
Passive ETFs that mimic an index such as Vanguard's offerings will reflect any differences in index performance and as Canadian Capitalist's review of the news shows, the FTSE and the MSCI year-by-year and cumulative performance for the same category of fund - e.g. stocks of Emerging Markets countries - has differed a fair bit. The FTSE has garnered higher returns than the MSCI index by about 13% in total over the past ten years, according to IndexUniverse's Vanguard Changes Tricky for Investors. Of course, that difference from portfolio composition might not continue and might reverse over the next ten years.

3) South Korea - One big portfolio difference
It's not just Vanguard that is affected. FTSE, MSCI, Standard & Poors and Dow Jones all license their indices to various ETF providers who create ETFs to track those indices. What the indices include or exclude makes a big difference. The biggest difference currently is whether South Korea is considered a developed or an emerging market country and whether its stocks go into the ETF for that category. FTSE and S&P say it is a developed country, while MSCI and Dow Jones classify it as emerging.

South Korea matters. Its economy is the 12th largest by one measure of GDP cited by Wikipedia, ahead of Canada at 14th. It features huge companies like Samsung, Hyandai, Posco and Kia. If your intent as an investor is to hold a passive globally diversified portfolio, South Korea and its companies should be represented.

The problem is that by picking different combinations of ETFs based on different indices, supposedly covering different countries, South Korea may end up missed entirely, or duplicated (more on this in our post about "diworsifying").

A wider ETF problem - Inclusion or exclusion of Canada and the USA too
The problem isn't just South Korea, it happens with Canada and the USA too. Depending on the ETF and its index, broad multi-country ETFs can either include or exclude Canadian and US equities. For most investors the issue is likely to be duplication of holdings that are already in the single country ETFs they own as a core position, such as BMO's S&P/TSX Capped Composite Index (TSX: ZCN) for Canada or the SPDR S&P 500 (NYSE: SPY) for the USA.

The ETF Maze Map
To help investors sort through the confusion and pick which combinations of ETFs can go together to avoid duplications or omissions, we created the chart below. It shows the ETF provider and ticker symbols under the commonly used titles like Global/World, International, Developed, EAFE and Emerging and whether they exclude Canada, the USA or South Korea. In the chart, if those countries are not shown as excluded, by definition they are included. We also show Vanguard's ETFs as they will be after the index change to FTSE, though Vanguard intends to gradually transition the portfolio changes over several months starting in January 2013. The yellow line separates the category of about 46 Frontier countries, ranging from Argentina to Vietnam, since those countries do NOT figure in any of the World/ Global ETFs, despite the name. (Why a country like Greece still appears in everyone's Developed country ETFs while Kuwait, Oman and Qatar are no better than Frontier is a bit puzzling but the index providers make those decisions and the ETF providers follow.)

Example: buying Vanguard's VWO (Emerging Market) along with iShares Canada's XWD (Developed Market, though they call it World) means that South Korea is totally excluded (!) while Canada and the USA are included! If you also buy ZCN and SPY, you've got a lot of duplication - the USA is more than half of XWD, so if the USA/SPY is 20% of your portfolio and Developed/XWD is also 20%, your USA holding is actually 20% + half of 20% = 30% in total.

Beyond the ETFs and groupings on the chart, there exists in the ETF space a raft of sub-groupings of countries by region, like Europe, Asia, Pacific etc, or by custom creation, like BRIC (Brazil, Russia, India, China). Sub-dividing a portfolio with extra ETFs can get more complicated, though some investors may want to do it e.g. when they believe, as we suggested could well be the case in our recent post on European equities, that special opportunities exist. Hopefully, with the help of our chart, investors will at least know what they are buying and not get trapped in the maze.

Details of Country Classifications:

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

1 comment:

Canadian Capitalist said...

Thanks for the mention Jean. If one holds VEA + VWO then, South Korea will still be represented after the switch. It's a very useful reminder to pay attention to country composition of other ETF combinations.