An Emerging Problem for this ETF

There's been so much misguided, hyped information regarding ETFs, that I have enjoyed writing several pieces in the past month on several of the flaws and myths surrounding the investment structure.

This past week I read an article that's worthy of pointing out. IndexUniverse.com highlights two ETFs that track the MSCI Emerging Markets Index, but have very different returns. Vanguard's VWO and iShares EEM both track the emerging markets index, but they differ in return by four percentage points.  Why the disparity?

It turns out that VWO holds all of the stocks in the index (full replication strategy) and EEM holds only a portion of the stocks in the index (optimization strategy). This optimization strategy hasn't worked well for EEM.

Optimization strategies are also used by index mutual funds. In some cases, index funds and ETFs may hold a subset of the stocks in an index if the index includes a number of fairly illiquid names or, simply, owns a lot of stocks.

The moral of the story is that you need to know what your funds own (whether it's an ETF or a mutual fund), by reading the prospectus.