The iShares Emerging Markets ETF Does a Poor Job of Tracking the MSCI Emerging Markets Index

The iShares Emerging Markets ETF (symbol: EEM) and the Vanguard Emerging Markets ETF (symbol: VWO) both track the same index, the MSCI Emerging Markets Index. However, iShare's EEM has underperformed the underlying index by about 5% so far in 2007 due to a tracking error. Through the end of August 2007, EEM had appreciated about 17.33% for the year, whereas Vanguard's VWO had appreciated about 22.10%. The reason for the performance difference from the two ETFs that track the same index is due primarily to sampling techniques and, to a lesser extent, the larger expense ratio of EEM (0.75%) versus that of VWO (0.30%).

Index funds often fail to purchase all of the securities in the index being tracked. As I understand it, the funds often do this because some of the securities in the index are not very liquid and the purchase of even a small number of shares can substantially move the price of some securities. Moreover, the transaction costs can theoretically be reduced by purchasing a smaller number of different securites in a smaller number of trades.

There are 830 different securities in the MSCI Emerging Markets Index. iShares' EEM holds shares of 552 securities of the MSCI Emerging Markets Index. VWO, on the other hand, holds shares of 858 securities (i.e., VWO holds shares of some securities that are not even in the index in an effort to better track the index).

I'm not sure how iShares decides which of the securities to hold and which to avoid. However, EEM's 5% tracking error this year is very disconcerting. I own shares of EEM in my own accounts. I purchased them a couple years ago because EEM had a much larger trading volume than VWO and the bid/ask spread was lower. However, the trading volume of VWO has definitely increased over the past year or so and the bid/ask spread has been decreasing. From now on, I will probably only purchase shares of VWO because it does a much better job of tracking the MSCI Emerging MArkets Index.