Tracking Error in Emerging Markets ETFs

In a comment to an earlier post (see New iShares Emerging Market and World ETFs), Henry noted that the iShares MSCI Emerging Markets ETF (EEM) seemed to track the index better than the Vanguard Emerging Markets ETF (VWO). As you can see from the Google Finance chart below, since 2007 EEM’s return is more than 2% better than VWO.

Since both ETFs track the same MSCI Emerging Markets Index (VWO’s mandate was changed to track this index in August 2006), it was puzzling why there should be a significant difference in performance between the two. In fact, EEM has a significant tracking error as you can see in the table below (negative tracking error means ETF returns were higher than the index):

The difference in tracking errors is probably due to the different methods employed by the ETFs to track the index. The MSCI Emerging Markets Index has 733 stocks but VWO holds 791 (probably due to some overlap between stocks listed in emerging markets and ADRs) and EEM only 338. It seems that Vanguard tries to replicate the index as much as possible while iShares employs “representative sampling” to track the index. According to the iShares prospectus:

“Representative sampling” is an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to the Underlying Index. The securities selected are expected to have, in the aggregate, investment characteristics (based on factors such as market capitalization and industry weightings), fundamental characteristics (such as return variability and yield) and liquidity measures similar to those of the Underlying Index.

Over a longer time-frame, EEM it appears that the iShares sampling strategy is successful. Since inception the tracking error of EEM is -0.28%.

PS: The winner of the Thrill of a Lifetime giveaway is Sam for his comment on Four Pillars. Thanks to everyone for participating.