Want to build a broadly diversified international stock portfolio? It might seem a logical choice could be using two funds such as the Vanguard FTSE Developed Markets ETF (VEA) and the iShares Core MSCI Emerging Markets ETF (IEMG). After all, IEMG has earned 30.4% this year through Oct. 6 versus 26.5% for the Vanguard FTSE Emerging Markets Index Fund ETF (VWO).
Between developed countries and emerging markets, it may appear as if you own the rest of the world, but appearances can be deceiving.
Though you might not find it surprising that Samsung Electronics is the second-largest holding of IEMG, you might be surprised to learn it’s also the fourth-largest holding of VEA. That’s because FTSE includes South Korea in its developed markets index, while MSCI includes it in its emerging markets index.
Fund index providers use different methodologies that go beyond which countries are included.
In the example above, the two funds would have worked out well due to doubling up on South Korea, as the biggest driver of the performance differences between the iShares and Vanguard emerging market funds is South Korea. Specifically, Samsung has gained 43.1% so far this year. But using different fund families could have just as easily inadvertently excluded South Korea.
2 Ways Of Avoiding Danger
The most obvious way of avoiding this is to stick to one index provider, which typically means using the same fund family. Providers like FTSE and MSCI are unlikely to have overlaps within their own indexes.
My preferred solution, however, is to avoid the issue completely by owning broader funds such as the iShares Core MSCI Total International Stock ETF (IXUS), or the Vanguard Total International Stock ETF (VXUS).
Though this doesn’t allow one to overweight emerging markets, there is little evidence that faster GDP growth leads to better stock performance. On the other hand, there is ample evidence that investors performance-chase. In 2015, with poor emerging market performance, VWO had the third-largest fund outflows and this year, after strong performance, the eighth-largest inflows.
How To Approach This Issue
I’m a believer that broader is better. We never know which segment of the market is going to be the best performer. I suspect that not many would have guessed the South Korean stock market would have been such a strong performer given potential dangers of war with North Korea, with Seoul merely 35 miles from the border.
This illustrates a second point: Markets are hard to predict, even with the hindsight of world events. Thus, a broad approach leads to less performance-chasing.
But an extra benefit is that you don’t have to worry about the consistency of mixing indexes, or changes to those indexes. Such changes can lead to inconsistencies within your portfolio, not to mention tax implications to correct.
At the time of writing, the author held VXUS. Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at ar@DareToBeDull.com or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter