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Ask Bender: Diversification of iShares ETFs vs. Vanguard ETFs

June 13, 2016 - 8 comments

Q:  “Why do some people still use XEF/XEC vs. VIU/VEE, since both VIU and VEE are more diversified?”

As new ETFs are released, it’s natural for index investors to succumb to what I like to call “ETF envy”.  I often witness it when an ETF provider lowers their fees below that of their competitors’ – this is usually met with investor excitement as they frantically switch their higher-cost fund to the lower-cost alternative.  As one would expect, the higher-cost provider usually follows suit by lowering their fee to match.

This can be detrimental to an investor’s financial health if it causes them to realize unnecessary trading costs, bid-ask spreads and capital gains in pursuit of a temporarily superior product.

Hard-core index investors also tend to exhibit this behavior while in search of the most diversified ETF.  If we base our decision simply on the number of underlying index holdings that an ETF tracks, Vanguard would beat iShares hands down (7,075 stocks vs. 5,766 stocks).  However, it is important to dig a little deeper with our analysis to ensure we have not missed any subtleties that may impact our decision.

iShares ETFs

Security MER Underlying Index Number of Stocks
in the Index
iShares Core MSCI EAFE IMI Index ETF (XEF) 0.22% MSCI EAFE IMI Index 3,082
iShares Core MSCI Emerging Markets IMI Index (XEC) 0.26% MSCI Emerging Markets IMI Index 2,684
Total     5,766

Sources: BlackRock Canada, MSCI Index Fact Sheets as of May 31, 2016

Vanguard ETFs

Security MER Underlying Index Number of Stocks
in the Index
Vanguard FTSE Developed All Cap ex North America Index ETF (VIU) 0.22% FTSE Developed All Cap ex North America Index 3,496
Vanguard FTSE Emerging Markets All Cap Index ETF (VEE) 0.24% FTSE Emerging Markets All Cap China A Inclusion Index 3,579
Total     7,075

Sources: BlackRock Canada, MSCI Index Fact Sheets as of May 31, 2016

The inclusion of China A shares in FTSE indices

In May 2015, FTSE released several new emerging markets indices, which included a modest allocation to China A shares (about 5%).  In November 2015, Vanguard began transitioning to these new indices, which currently include an additional 1,541 China A shares.

Although this may sound impressive, the 1,541 additional China A shares account for only 1.18% of the total developed/emerging markets allocation.  To put this into perspective, for a balanced Couch Potato portfolio that allocates 20% to VIU/VEE, only 0.24% of your entire portfolio will hold the additional China A shares.

Sources: MSCI and FTSE Index Fact Sheets as of May 31, 2016 *77.43% MSCI EAFE IMI Index + 22.57% MSCI Emerging Markets IMI Index **80.03% FTSE Developed All Cap ex North America Index + 19.97% FTSE Emerging Markets All Cap China A Inclusion Index

MSCI on a slow boat to China

Although MSCI has not yet added China A shares to their indices, it is only a matter of time until they do (MSCI will be announcing their next China A share inclusion decision on June 14, 2016). MSCI has proposed an initial 5% partial inclusion of China A shares (or about 1.1% of their emerging markets index). If they move ahead with this proposal, it will take effect in June 2017.  The initial allocation will be less than the amount FTSE started out with, but will likely include a larger number of stocks (which may in turn make XEF/XEC look more diversified than VIU/VEE).

In the end, there is no right or wrong decision.  Both pairs of ETFs will provide adequate diversification for investors. MSCI and FTSE will eventually have a similar allocation to China A shares in their emerging markets indices, so any significant differences in weights or stock holdings is expected to be temporary.

By: Justin Bender with 8 comments.
  19/09/2016 10:03:26 AM
Justin Bender
@Franko: Your analysis is likely coming from different sources with different methodologies. Using Morningstar Direct, I found the following size breakdown for the two ETFs:

VEE = 80.9% large + 14.9% mid + 4.2% small
XEC = 79.2% large + 14.7% mid + 6.1% small

If you take a balanced portfolio without emerging markets (40% FTSE TMX Canada Universe Bond Index + 20% MSCI Canada Index + 20% MSCI USA Index + 20% MSCI EAFE Index) and carve out a small allocation for emerging markets, your return has historically been slightly higher with a higher risk and higher Sharpe ratio (40% FTSE TMX Canada Universe Bond Index + 20% MSCI Canada Index + 20% MSCI USA Index + 16% MSCI EAFE Index + 4% MSCI Emerging Markets Index):

1988 to 2015:

Without EM: 8.57% annualized return, 7.76% standard deviation, 0.5580 Sharpe ratio

With EM: 8.85% annualized return, 7.82% standard deviation, 0.5895 Sharpe ratio
  18/09/2016 11:11:49 PM
Hi Justin,

When analyzing VEE and XEC by market cap, it seems that VEE has a substantially higher weighting towards mid and small cap stocks than XEC (VEE has at most a 30% allocation to large caps while XEC has 70%). Do you feel like this impacts one's choice of fund significantly?

Also, regarding your comment that emerging market equities have historically produced slightly higher returns/volatility - would it be possible for you to provide the research you're referencing for that? I have a fair bit of my portfolio in emerging market investments for the reasons you stated, but I've had trouble finding proper data supporting the "higher returns" bit.

Thanks kindly!

  27/06/2016 10:22:30 PM
Justin Bender
@Shaun - we only included plain-vanilla broad market ETFs in the white paper update this time around.

I'm not positive whether or not the new Vanguard ETFs hold the underlying stocks directly, but I assume that they would be required to, as Vanguard US does not have any similar ETFs that I am aware of (although the UK recently released similar factor-based ETFs).

When Vanguard Canada's semi-annual financial statements are released, you can view the exact holdings and determine whether the ETFs are a wrap structure.
  23/06/2016 2:45:34 PM
Hi again Justin. I am looking forward to reading your paper. I suspect the 4 new Vanguard factor ETFs (VLQ, VVO, VMO,VVL) will not be included. Do you know if they are "wrapped". How do I find out if they are on my own?

  21/06/2016 2:53:03 PM
Justin Bender
@Shaun - you're correct - from a foreign withholding tax viewpoint, XEC and VEE are wrapped and would be expected to have more tax drag (especially in a TFSA or RRSP account). We should be releasing our Foreign Withholding Tax white paper update over the next week, so you'll be able to compare the estimated costs.
  21/06/2016 2:28:00 PM
I believe both XEF and VIU are hold stocks directly in foreign markets for better tax efficiency, but both XEC and VEE are wrapped in the US and are less tax efficient. Is this correct?
  14/06/2016 9:53:24 AM
Justin Bender
@Anne - historically for Canadian investors, allocating a portion of a balanced portfolio to emerging market equities has resulted in slightly higher performance with higher volatility. It also would have had a higher Sharpe ratio (i.e. higher risk-adjusted returns).
  13/06/2016 5:33:33 PM
Given the very high correlation between Canadian indexes and EM indexes, is there really any diversification or performance benefits to holdin EM if one has 20% or more of a portfolio in Canada?

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