Investing overseas is important for Australians. The local share market is dominated by a few big banks, miners, and retailers. The glamorous IT and pharmaceutical sectors, which have proved such a boon for Swiss and US companies in recent years, are mostly missing in Australia. And as Australia only makes up 2% of the global GDP, its crucial for investors to go overseas.
As far as global share ETFs go, the two that get most discussed are the Vanguard MSCI Index International Shares ETF (VGS) and the iShares Core MSCI World All Cap ETF (IWLD). Both are super cheap, well diversified and from two of the most famous ETF issuers. But what are the differences investors need to know? And which is better? We take a look.
- Do you want small caps and Australia?
The investment strategies VGS and IWLD follow are very similar: they buy the global share market and weight every company by size. Both do so by tracking versions of the MSCI World index, which is perhaps the most famous global share market gauge. The approach means that the US takes up a two-third majority of both VGS and IWLD’s assets.
|Ticker||Fund Name||Benchmark||AUM ($M)||Inception|
|VGS||Vanguard MSCI Index International Shares ETF||MSCI World ex-Australia index||2,100||Nov-14|
|IWLD||iShares Core MSCI World All Cap ETF||MSCI World Investable Market index||121||Apr-16|
There are two subtle differences between the two though. First, and perhaps less importantly, IWLD tracks a version of the MSCI World that includes Australia, which makes up around 2.5% of its assets. Second, and perhaps more importantly, the MSCI benchmark IWLD tracks includes smaller companies. VGS only includes large and medium-sized global companies.
Structure and tax
- Fund of funds, or plain old ETF?
The most crucial difference between IWLD and VGS is how they’re structured. VGS is just a plain old Aussie-domiciled fund. It buys and holds the shares that are in its index and that’s it.
IWLD, however, is a bit of a different fish. It is built as a fund of funds (FoF), meaning it buys other iShares ETFs – all of which are domiciled in North America – and does not directly hold any shares. The fees of the underlying iShares ETFs are then rebated, so there is no double dipping on iShares’ part. (A common worry for investors considering IWLD).
|VGS Holdings (top 10)|
|Facebook Inc. Class A||1.14%|
|JPMorgan Chase & Co.||0.99%|
|Alphabet Inc. Class C||0.98%|
|Alphabet Inc. Class A||0.91%|
|Johnson & Johnson||0.85%|
|Visa Inc. Class A||0.75%|
The FoF approach has the benefit of making things cheap. Because iShares’ Australian and Hong Kong staff didn’t have to build IWLD from scratch, and because they can piggyback off existing popular iShares ETFs, they can provide IWLD at an ultra-low cost. In theory, the FoF approach should also help make IWLD more liquid, as market makers have to source fewer securities when creating IWLD. (In practice, it doesn’t necessarily work like that. Discussed below).
|iShares Core S&P 500 ETF||55.87%||USA|
|iShares Core MSCI EAFE ETF||33.71%||USA|
|iShares Core S&P Small Cap ETF||6.89%||USA|
|iShares S&P/TSX Capped Composite ETF||3.47%||Canada|
How IWLD is taxed
- Do you trust BlackRock’s tax lawyers?
There are potential complications of IWLD’s FoF approach. These mostly concern taxation, which is particularly critical for the iShares Core MSCI EAFE ETF (IEFA), which is IWLD’s second largest holding. IEFA invests in companies based in rich European and Asian countries (including Australia). This means it has to pay taxes where the companies are based as well as where the fund is based.
For example, Nestle is a Swiss company and IEFA’s biggest holding, meaning Swiss taxes apply. Then, as the fund is US-domiciled, it cops US taxes too. This means Nestle’s dividend gets taxed twice.
This tax inefficiency would, on the surface, suggest VGS is a better product. However, there is more to it. Specifically, IWLD can get some of that double tax back. How? Well, to simplify egregiously, most governments have agreements that stop the doubling up of taxes on foreign investors. This means that once investors pay their first round of withholding taxes, any additional withholding taxes can trigger tax credits elsewhere that can be reclaimed in certain ways.
Now I’m not fully sure how this works in any detail. But I do know that BlackRock has tax lawyers that are paid lots of money. And looking at the end result, iShares and Vanguard’s dividend yields are very similar.
|Fund coverage||Ticker||Historical Yield|
Fees and liquidity
- VGS has a higher management fee, but lower spreads and internal costs
Management fees are always the first thing that comes into investors’ minds these days when ETFs are discussed. And here IWLD has a clear advantage, charging half what VGS does. Its tiny 9bp fee makes it one of the cheapest in Australia.
However, the gains on IWLD’s management fees are more eaten away by the higher spreads. Spreads are particularly significant for traders, or for short term holders. As traders rarely hold a fund the whole year, they don’t wear the full management fee. Whereas they pay the spread every time they buy and sell.
|Average 52 Week Premium||0.04%||0.23%|
IWLD also has higher turnover, which implies higher “internalised” costs. Turnover comes when the underlying ETFs get rebalanced. They cause higher transaction costs and capital gains taxes. In the case of IJR – the small cap ETF IWLD holds – the index turnover is 14% a year. VGS by contrast has negligible turnover, which helps keeps costs and tax down.
|Annual Portfolio Turnover Rate||0.6%||6.60%|
*Calculated as the weighted average turnover of the underlying ETFs
The final higher cost worn by IWLD is cash drag. All ETFs have some leftover cash from rebalances. This cash acts as a drag on performance in a rising market (and creates tracking error, discussed more below). Most ETF providers are sure to tuck this cash away in futures when certain thresholds are hit. Here, however, VGS has an advantage again. Because there is only one ETF with VGS, there is only one place cash drag occurs. IWLD by contrast incurs cash drag on two levels: the underlying ETF level, and on the fund of fund level.
How IWLD’s creation baskets are optimised for tracking (wonkish, feel free to skip)
A final concern for IWLD is how its is actually put together, and whether the underlying ETFs allow it to accurately track its index. The ETFs IWLD holds track indexes from different companies, some are from MSCI, others are from S&P Global. This raises obvious questions about how creation baskets are optimised to ensure the fund tightly tracks its index. We asked iShares about this. The answer we got suggests that iShares uses Aladdin, their proprietary portfolio building software, to make sure the underlying stocks IWLD holds closely matches its index.
Block trading (wonkish, feel free to skip)
- IWLD should make for easier block trades
The core liquidity function for block trades comes from an ETF’s creation basket. The way block trades work is that market makers – usually at the request of ETF providers’ capital markets desks – source the underlying securities then put a creation order through. Market makers then pass on the costs of basket financing to investors, while adding a spread of their own. This means that block trade spreads are determined by the accessibility of the underlying securities, including the availability of hedges.
Because IWLD’s creation basket is simply four hyper-liquid ETFs with massive volumes, all of which have easy hedges, one would expect block trades to be very straightforward and in fact quite cheap. VGS by contrast has 1,500+ securities in its basket, which have to be sourced line by line. The weighted average spread on VGS’s basket is higher than IWLD’s. Meaning that basket financing should be more expensive.
However, from what we can tell, there have been no block trades on IWLD yet.
Performance, tracking error and risk
- Basically the same
On a price return basis, IWLD has beaten VGS since inception. However on a total return basis – which includes dividends – VGS has been the better performer over the past three years. However, as both products track similar indexes we suspect performance will be broadly comparable over the years.
|Returns – Year to date||29.22%||28.22%|
|Returns – 1 year||23.74%||22.34%|
|Returns – 3 year||15.85%||14.92%|
In terms of risk, again, both funds are similar. Using standard deviation, which is perhaps the most common risk measure, there doesn’t appear to be any difference.
|3 YR Standard Deviation||9.95||9.95|
|Median Market Cap||73 billion||103 billion|
- VGS might be slightly better
VGS and IWLD are both good funds. Investors could not really go wrong with either of them. VGS has the advantages of coming in a neater package, with lower internal costs and better trading. IWLD has the advantages of including smaller companies, which have historically outperformed, and a lower management fee.
Personally, I lean towards VGS, just because I like the simplicity and do not have to second guess any of the tax stuff. For those wanting small caps, there is always VISM, the Vanguard international small cap ETF.