In the last three installments of my “Understanding ETFs” series, we toured the developed markets equity ETF landscape. Of course, when it comes to investing, you don’t have to limit yourself to developed countries. As you can see in the world view below, there’s a lot of turf to be covered by venturing into the blue-coloured emerging or developing markets.

 

Today, we’ll explore how to further diversify your portfolio by adding ETFs that invest in emerging stock markets around the globe.

 

 

The Emerging ETF Landscape

In 2003, BlackRock released the iShares MSCI Emerging Markets ETF (EEM). MSCI is an acronym for “Morgan Stanley Capital International”. EEM tracks the performance of over 1,000 large and mid-size companies located in 24 emerging countries around the world.

The “BRICS” countries – Brazil, Russia, India, China and South Africa – make up about 57% of the fund’s total country allocation.

 

Top 10 Countries by EEM Weight

CountryWeight
China30.3%
Korea13.7%
Taiwan11.4%
India9.4%
Brazil7.5%
South Africa6.2%
Russia3.7%
Mexico2.8%
Thailand2.4%
Malaysia2.4%

Source: BlackRock Inc., as of December 31, 2018

 

As EEM trades in U.S. dollars on the U.S. stock exchange, Canadian investors may find it more convenient to purchase the iShares MSCI Emerging Markets Index ETF (XEM) instead. XEM follows the same index, but trades in Canadian dollars on the Canadian stock exchange. However, its cost is relatively high, at 0.82% per year.

Investors may be better off purchasing the BMO MSCI Emerging Markets Index ETF (ZEM), which also trades on the Canadian stock exchange in Canadian dollars, but has an annual cost of just 0.27%. ZEM also holds about 85% of its stocks directly, making its structure slightly more tax-efficient than XEM.

 

U.S.-ListedCanadian-Listed
iShares MSCI Emerging Markets ETF (EEM)- iShares MSCI Emerging Markets Index ETF (XEM)
- BMO MSCI Emerging Markets Index ETF (ZEM)

 

Each company in the MSCI Emerging Markets Index is weighted according to its “float-adjusted” market capitalization. For more information on float-adjusted market caps, please watch my video, Understanding Canadian Equity ETFs.

 

Engaging in Small Talk

In 2011, BlackRock also launched the iShares MSCI Emerging Markets Small-Cap ETF (EEMS). EEMS complements EEM by following the MSCI Emerging Markets Small Cap Index, which tracks the performance of over 1,500 smaller companies located in the emerging economies.

 

Tracking ETFSymbolMERUnderlying IndexNumber of StocksDividend Yield
iShares MSCI Emerging Markets ETFEEM0.69%MSCI Emerging Markets Index1,1252.9%
iShares MSCI Emerging Markets Small-Cap ETFEEMS0.69%MSCI Emerging Markets Small Cap Index1,5872.9%

Sources: BlackRock Inc., MSCI, as of December 31, 2018

 

By allocating about 89% of your EM equity investment dollars to EEM, and the remaining 11% to EEMS, you gain float-adjusted market-cap exposure to most emerging markets stocks, at an annual MER of about 0.69%.

 

If You Can’t Beat ’Em, Join EEM

As you may have already pieced together, there also is a single index that follows a combination of the MSCI Emerging Markets Index and the MSCI Emerging Markets Small Cap Index. It’s called the MSCI Emerging Markets IMI Index.

“IMI” stands for “Investable Market Index”, which includes large, mid-size and small-size companies. This index follows the performance of over 2,700 emerging companies, providing broad stock market exposure.

As you might expect from my previous videos, there are yet again ETFs available that track this more diversified index.

The iShares Core MSCI Emerging Markets ETF (IEMG) trades on the U.S. stock exchange in U.S. dollars. IEMG tracks over 2,700 emerging markets stocks and has a cost of 0.14% per year. In addition, its sister ETF, the iShares Core MSCI Emerging Markets IMI Index ETF (XEC), trades on the Canadian stock exchange in Canadian dollars.

 

Tracking ETFSymbolMERUnderlying IndexNumber of StocksDividend Yield
iShares Core MSCI Emerging Markets ETFIEMG0.14%MSCI Emerging Markets IMI Index2,7122.9%
iShares Core MSCI Emerging Markets IMI Index ETFXEC0.26%MSCI Emerging Markets IMI Index2,7122.9%

Sources: BlackRock Asset Management Canada Limited, BlackRock Inc., MSCI, as of December 31, 2018

 

XEC has an MER of 0.26%, and simply invests in its U.S.-listed counterpart ETF, IEMG, to gain exposure to emerging markets stocks. This wrap structure makes XEC less tax-efficient than IEMG when held in a tax-deferred account (such as an RRSP, LIRA, RRIF or LIF). This extra tax drag is due to the additional 15% U.S. withholding taxes that apply on foreign dividends paid to Canadian investors from the underlying U.S. fund. For more information on foreign withholding taxes, please refer to our white paper on the subject, but here’s a quick overview of their expected impact.

 

Estimated Unrecoverable Foreign Withholding Taxes: IEMG vs. XEC

Account TypeiShares Core MSCI Emerging Markets ETF (IEMG)iShares Core MSCI Emerging Markets IMI Index ETF (XEC)
Registered Retirement Savings Plan (RRSP)0.31%0.68%
Registered Retirement Income Fund (RRIF)0.31%0.68%
Locked-in Retirement Account (LIRA)0.31%0.68%
Life Income Fund (LIF)0.31%0.68%
Tax-Free Savings Account (TFSA)0.68%0.68%
Registered Education Savings Plan (RESP)0.68%0.68%
Registered Disability Savings Plan (RDSP)0.68%0.68%
Taxable Accounts0.31%0.31%

Sources: BlackRock Asset Management Canada Limited, BlackRock Inc., MSCI, as of December 31, 2018

 

Driving My VWO

In 2005, Vanguard U.S. released the Vanguard FTSE Emerging Markets ETF (VWO). VWO follows the FTSE Emerging Markets All Cap China A Inclusion Index, which tracks the performance of over 4,000 companies located in 23 emerging countries around the globe. This makes it similar to IEMG. As discussed in earlier installments, “FTSE” stands for “Financial Times Stock Exchange”, and “All Cap” indicates that the index tracks large, mid-cap, and small-cap companies.

Before you get too excited about the 4,000 plus holdings in VWO, know that over 1,000 of these holdings are small cap China A shares, which currently account for less than 1% of the fund. I’ll discuss China A shares in more detail in an upcoming video.

In 2011, Vanguard Canada launched a Canadian-version of VWO, the Vanguard FTSE Emerging Markets All Cap Index ETF (VEE). VEE has an MER of 0.24%, and simply invests in its U.S.-listed counterpart, VWO, to gain exposure to emerging markets stocks. This wrap structure makes VEE less tax-efficient than VWO when held in a tax-deferred account (such as an RRSP, LIRA, RRIF and LIF). Again, we’ll show that below.

 

Tracking ETFSymbolMERUnderlying IndexNumber of StocksDividend Yield
Vanguard FTSE Emerging Markets ETFVWO0.14%FTSE Emerging Markets All Cap China A Inclusion Index4,0323.1%
Vanguard FTSE Emerging Markets All Cap Index ETFVEE0.24%FTSE Emerging Markets All Cap China A Inclusion Index4,0323.1%

Sources: The Vanguard Group, Inc., Vanguard Investments Canada Inc., FTSE Russell Indices, as of December 31, 2018

 

Estimated Unrecoverable Foreign Withholding Taxes: VWO vs. VEE

Account TypeVanguard FTSE Emerging Markets ETF (VWO)Vanguard FTSE Emerging Markets All Cap Index ETF (VEE)
Registered Retirement Savings Plan (RRSP)0.31%0.71%
Registered Retirement Income Fund (RRIF)0.31%0.71%
Locked-in Retirement Account (LIRA)0.31%0.71%
Life Income Fund (LIF)0.31%0.71%
Tax-Free Savings Account (TFSA)0.71%0.71%
Registered Education Savings Plan (RESP)0.71%0.71%
Registered Disability Savings Plan (RDSP)0.71%0.71%
Taxable Accounts0.31%0.31%

Sources: BlackRock Asset Management Canada Limited, BlackRock Inc., FTSE Russell Indices, MSCI, The Vanguard Group, Inc., Vanguard Investments Canada Inc. as of December 31, 2018

 

Define “Emerging”

There are a number of notable differences between the MSCI and FTSE emerging markets indices. Plus, the country classifications are in a constant state of flux. It’s probably best to consider emerging market investing as an even more inexact science than usual. At least at the moment, here are some of the variations on the theme:

• MSCI classifies Korea as an emerging market, so includes about 422 Korean companies in the MSCI Emerging Markets IMI Index. (As you’ll recall from my last video, FTSE classifies Korea as a developed country, and therefore includes about 418 Korean companies in the FTSE Developed All Cap ex North America Index instead.)

• MSCI classifies Poland as an emerging market, so includes about 37 Polish companies in the MSCI Emerging Markets IMI Index. FTSE classifies Poland as a developed market, so includes about 37 Polish companies in its FTSE Developed All Cap ex North America Index.

• MSCI classifies Kuwait as a frontier market, so excludes it from both its developed and emerging markets indices. FTSE considers Kuwait to be an emerging market, so includes about 13 companies of Kuwait in its FTSE Emerging Markets All Cap China A Inclusion Index.

• Both MSCI and FTSE include a portion of China A shares within their emerging markets indices. However, MSCI currently only includes about 234 large cap China A share companies, while FTSE includes around 1,915 large-, mid- and small-cap China A share companies.

 

Market Classification

CountryFTSEMSCI
KoreaDevelopedEmerging
PolandDevelopedEmerging
KuwaitEmergingFrontier

Sources: FTSE Russell Indices, MSCI, as of December 31, 2018

 

As shown in this chart, IEMG and XEC each currently allocate about 14% of their holdings to Korean stocks, while in turn underweighting many of their other top country holdings, relative to VWO and VEE.

 

Top Country Weights: IEMG/XEC vs. VWO/VEE

CountryIEMG/XECVWO/VEEDifference
China28.2%33.7%-5.5%
Korea14.2%-+14.2%
Taiwan12.2%14.1%-1.9%
India10.2%12.0%-1.8%
Brazil7.3%8.5%-1.2%
South Africa6.1%6.9%-0.8%
Russia3.4%3.7%-0.3%
Mexico2.8%3.2%-0.4%
Thailand2.6%3.9%-1.3%
Malaysia2.5%3.3%-0.8%

Sources: BlackRock Asset Management Canada Limited, Vanguard Investments Canada Inc., as of December 31, 2018

 

Even with this relatively large difference in country holdings, the ETFs’ underlying indices have had similar performance between 2006–2018. This may not be the case going forward, but during this period, the FTSE Emerging Markets All Cap ex China A Inclusion Index returned 6.4% in Canadian dollars on an annualized basis, while the MSCI Emerging Markets IMI Index returned 6.2%.

 

 

The Korean Conundrum

We’re getting close, but we’re not yet done with our ETF world tour! Now that you have a number of international and emerging markets equity ETFs to choose from, I’ll show you in my next video how to properly combine them, so you’re neither excluding Korea from your portfolio, nor unintentionally over-weighting it.

 

Tracking ETFSymbolMERUnderlying IndexNumber of StocksDividend Yield
iShares Core MSCI Emerging Markets ETFIEMG0.14%MSCI Emerging Markets IMI Index2,7122.9%
iShares Core MSCI Emerging Markets IMI Index ETFXEC0.26%MSCI Emerging Markets IMI Index2,7122.9%
Vanguard FTSE Emerging Markets ETFVWO0.14%FTSE Emerging Markets All Cap China A Inclusion Index4,0323.1%
Vanguard FTSE Emerging Markets All Cap Index ETFVEE0.24%FTSE Emerging Markets All Cap China A Inclusion Index4,0323.1%

Sources: BlackRock Asset Management Canada Limited, BlackRock Inc., FTSE Russell Indices, MSCI, The Vanguard Group, Inc., Vanguard Investments Canada Inc., as of December 31, 2018