5 Reasons EEM, VWO are not Bellwether EM ETFs

There is no getting around the fact that size matters with ETFs. In this case, size means assets under management. The ability of smaller ETFs to outperform larger rivals has been documented, but investors still flock to larger funds while eschewing those with light AUM totals.

Emerging market ETFs are a microcosm of investors' belief that bigger is better when it comes to ETFs. The Vanguard MSCI Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSE:EEM) are the third- and fourth-largest ETFs U.S.-listed ETFs by assets. At the end of July, the pair had a combined $86.9 billion in AUM and both had higher AUM totals in July than in June.

In other words, EEM and VWO are treated as bellwether emerging markets ETFs even though a compelling case can be made for why this pair should not be setting the course for the broader emerging markets universe. Here are a few reasons why:

South Korea and Taiwan This is not a knock on the iShares MSCI South Korea Index Fund (NYSE:EWY) or the iShares MSCI Taiwan Index Fund (NYSE:EWT), but the emerging markets status of these two countries has regularly been called into question over the past several years.

For example, the International Monetary Fund considers neither South Korea nor Taiwan to be an emerging market yet the two countries combine for 26 percent of EEM's weight. That alone implies EEM, VWO and the MSCI index the two funds track are antiquated measures of what truly constitutes a developing nation. This scenario cheats investors out of higher returns because there are nations that are legitimately emerging that have offered more upside than South Korea and Taiwan in recent years. Unfortunately, many of those countries receive only token exposure in EEM and VWO.

BRICS As in EEM and VWO are too heavily allocated to the Brazil, Russia, India, China and South Africa, also known as the BRICS quintet. In a more sanguine market environment, heavy BRICS exposure would be fine, but not this year. Each BRICS member is dealing with its own set of issues, in turn making it dangerous for investors to be overweight these countries.

Maybe EEM and VWO are not "overweight" the BRICS, but the five countries do account for nearly half of EEM's weight.

Mexico The iShares MSCI Mexico Investable Market Index Fund (NYSE:EWW) has been on a tear this year and Mexico is receiving plenty of praise from noteworthy investors.

EWW is up more than 17 percent year-to-date while VWO is up less than eight percent. EEM is higher by 6.34 percent.

Also of note: Mexico's 2011 GDP was higher than South Korea's, Taiwan and South Africa's.

Still, Mexico accounts for less five percent of EEM's weight.

Indonesia Apparently, size does not matter in terms of country weights within the MSCI Emerging Markets Index. If it did, Indonesia would be a more prominent member of EEM and VWO. After all, this is the fourth-largest country in the world by population and Southeast Asia's largest economy.

Last year, Indonesia's GDP was well above that of Taiwan and South Africa, yet Indonesia accounts for just 2.8 percent of EEM's weight. More alarming is the fact that Indonesia's 2011 GDP was more than double Malaysia's, but Malaysia has a larger allocation within EEM.

Since the Market Vectors Indonesia ETF (NYSE:IDX) came to market in January 2009, it has outperformed VWO by more than 150 basis points.

Did You Know? In 2011, Turkey's GDP easily surpassed Switzerland and Sweden's. Poland's GDP topped Belgium's. Thailand's economy was bigger than Norway's and far larger than Greece's. Colombia had a larger economy than Greece, Malaysia and Finland. Chile's GDP topped the output of Hong Kong, Israel and Portugal, just to name a few.

Combined, Thailand, Chile, Turkey, Poland and Colombia represent barely more than eight percent of EEM's weight. That serves as another indication EEM and VWO are far from the best way for investors to play emerging markets.

For more on emerging markets ETFs, click here.