Courtesy of Rosalyn Retkwa

When it comes to the broad-based emerging-markets equity ETFs, Vanguard’s MSCI Emerging Markets ETF (VWO) is clearly the top dog. As of December 11, VWO had a market cap of $58.66 billion and an average daily volume of 17.74 million shares.

But back on October 2, Vanguard rocked the ETF world when it said it would drop MSCI of New York City as its index provider on 22 ETFs and substitute two other index providers, in the belief that by doing so, it could achieve “considerable savings for the funds’ shareholders over time.” That includes VWO, which will transition to a FTSE index at some unspecified point next year. Vanguard has been deliberately vague about any sort of schedule.

“We’re not saying exactly when the transitions will begin in order to prevent front-running,” says Joel Dickson, a senior investment strategist and principal in Vanguard’s Investment Strategy Group in Malvern, Pennsylvania. “The transitions will be staggered over several months,” he says, noting that VWO “will take longer than the other funds because it will be divesting all of its holdings in South Korea and investing the proceeds in some markets that are less liquid.”

And VWO’s exposure to South Korea is the problem. As of its latest statement on October 31, VWO had a 15.3 percent weighting in South Korea, including its No. 1 stock holding, Samsung Electronics. And that entire position will have to be eliminated when VWO moves from the MSCI index to the FTSE index.

Among index providers, there’s a vigorous debate as to whether South Korea should be classified as emerging or developed, and while MSCI still considers it to be emerging because of stock market and currency constraints, FTSE upgraded it to the developed-nation status in September of 2008, and implemented the change a year later, says Jonathan Horton, the New York City–based president of FTSE North America and head of its exchange-traded product unit. There’s also a budding price war among ETF sponsors.

Still, the change in benchmarks is “a headache” for some institutional investors, says Dong Lee, the director of institutional sales at New York City’s WallachBeth Capital.  It often means they “have to present the investment case for the switch in indices in order to obtain board approval; and there’s a lot of work involved in that,” he says.

But will institutional investors switch to that other big dog of the category, BlackRock’s iShares MSCI Emerging Markets Index Fund (EEM), and in the process pay a much higher expense ratio of 67 basis points versus VWO’s 20 basis points to stick with MSCI? Continue reading →