Picking A Good Mutual Fund Or Etf

IShares MSCI Emerging Markets Index ETF and Vanguard Emerging Markets ETF 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 , 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 also has a similar advantage over its rivals, he said.

Dina Ting, portfolio manager at iShares, a unit of BlackRock Inc., 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.

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, by Sam Mamudi.

By: Arthur Miller

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