Asset allocation begins with assigning a specific percentage of your portfolio to each asset class. Then within each asset class, allocate more to those sectors with a higher-than-average expected return or those sectors which have a lower correlation to each other within the asset class. For example, with foreign stocks, emerging market stocks have the advantage of inexpensive labor costs and tend to outperform stocks in developed countries.

At age 40, we allocate about 10.6% to emerging markets in both our 2015 Gone Fishing Portfolio and our 2015 Vanguard Gone Fishing Portfolio.

Since its inception on April 7, 2003, iShares MSCI Emerging Markets ETF (EEM) has an annualized return of 11.98% through 7/31/2015. Had you invested in the fund at its inception, your investment would be up 303.16%. Recently, however, emerging markets have not been doing as well. Its 5-year annualized return is -0.15%. Cumulatively, your investment would be down 0.74% over the past 5 years.

Asset allocation means always having something to complain about. Although the last five years were not spectacular, during the five years before that (7/31/2005 through 7/31/2010) EEM had an annualized return of 11.84%.

Why are we investing in emerging markets? Emerging markets represent 49% of global domestic product but only 9% of market capitalization. The correlation between emerging markets and US stocks is lower than between foreign developed stocks and US stocks, which yields better diversification. And since the stock market trends upward over time, their volatility evens out in your favor over the long-term.

However, there are many emerging market funds to choose from. Here we are going to evaluate the choice between iShares MSCI Emerging Markets ETF (EEM) and Vanguard FTSE Emerging Markets ETF (VWO). Both are good choices.

Vanguard’s VWO has an expense ratio of 0.15% while iShares’ EEM has an expense ratio of 0.68%. This 0.53% difference in expense ratios is the primary reason we switched from using EEM to VWO when Vanguard launched it.

VWO and EEM are also based on different indexes. EEM is based on the MSCI Emerging Market Index and while VWO originally followed MSCI too, in 2013, it switched to the FTSE (pronounce Foot-see) Emerging Markets Index. The MSCI index (EEM) invests in large- and mid-cap stocks while the FTSE index (VWO) also includes small-cap. Because they follow different indices, they also contain different percentages in each emerging market country. Notably, the MSCI index includes South Korea while FTSE classifies South Korea as a developed country.

The full breakdown of countries for the MSCI Emerging Marketindex vs. the FTSE Emerging Market index is as follows:

• China: 23.85% vs. 27.1%
• South Korea: 14.26% vs. 0%
• Taiwan: 11.78% vs. 13.9%
• India: 8.82% vs. 12.7%
• South Africa: 8.09% vs. 9.5%
• Brazil: 6.87% vs. 8.3%
• Mexico: 4.66% vs. 5.4%
• Russian Federation: 3.67% vs. 4.3%
• Malaysia: 3.1% vs. 4.4%
• Indonesia: 2.29% vs. 2.4%
• Thailand: 2.2% vs. 2.4%

Because of the differences in country allocation, these stocks also differ in their emphasis on sectors of the economy. For instance, South Korea contains a lot of technology, which by its omission from the FTSE index will affect the FTSE allocation to technology. The breakdown for sectors of the economy for the MSCI Emerging Market index vs. the FTSE Emerging Market index is as follows:

• Financial: 29.09% vs. 31.5%
• Technology: 17.32% vs. 11.4%
• Consumer Discretionary: 9.11% vs.  9.7%
• Consumer Staples: 8.50% vs. 7.4%
• Telecommunication Services: 7.78% vs. 7.9%
• Energy: 7.63% vs. 8.6%
• Industrials: 7.18% vs. 10.3%
• Materials: 6.72% vs. 6.6%
• Utilities: 3.02% vs. 3.8%
• Health Care: 2.72% vs. 2.8%

These differences in the indices don’t come to much over the long term, but for a particular month can reach a few percentage points.

Here is a chart of the difference in investment value for $10,000 invested in both EEM and VWO from March 1, 2005 through 7/31,2015.

EEM has fallen a little behind VWO, probably because it has a higher expense ratio.

EEM has net assets worth $21.9 billion while VWO has net assets worth $44.4 billion.

EEM has 846 holdings while VWO has 1,023 holdings. The number of holdings reflects the fact that VWO includes more small-cap holdings. Larger funds often have lower expense ratios, better liquidity, and tighter spreads.

As a result, we prefer using Vanguard’s FTSE Emerging Markets ETF: VWO.

Photo used here under Flickr Creative Commons.