Thinking About Adding to Your International-Equity Allocation?

International equities have taken a large hit during the recent market slide. Those who are light in the asset class might want to consider adding to their allocation at this time. Within a diversified stock and bond portfolio, Morningstar advises investors to allocate about 15%-20% in international equities.

Cap-weighted index fund  Vanguard Total International Stock's (VXUS) annualized performance over the last 15 years was 28th percentile within the foreign large-blend category. (VXUS started trading on Jan. 26, 2011, so we used the fund's open-end sibling,  Vanguard Total International Stock (VGTSX), as a proxy for historical performance.) This respectable performance suggests that a cap-weighting strategy in international equities is a reasonable choice. However, part of this was driven by the stellar performance of emerging-markets stocks--VXUS' emerging-markets allocation of 16% is significantly higher than the category average of 7%. Capital investment-led growth out of China, which resulted in a global commodity boom, helped drive the performance of emerging-markets equities over the past decade. It is unlikely we will see another period of chart-topping, multiyear market rallies in emerging markets in the near or medium term, especially as China dials down its infrastructure spending.

Looking forward, we note that the financial sector, at 25%, accounts for a significant portion of VXUS. These holdings are dominated by the shaky European banks, as well as Japanese banks, which face plenty of uncertainty under the new, easy money environment. In the emerging markets, the large caps tend to be government-owned banks and energy companies or commodity players such as miners and tech hardware manufacturers--firms that do not effectively provide exposure to domestic growth trends. While we like VXUS' very low fees, we think investors might want to consider an actively managed international equity fund, in which a seasoned manager can avoid some of the big, relatively unattractive bets a cap-weighted strategy makes.

Fundamental View
European equities, which account for about 50% of this fund, face a challenging macroeconomic environment in the Greater European area. Deleveraging in the public and financial sectors has created a significant drag on the region's growth, and unemployment remains high at over 10%. The European economy likely will remain weak in the near term, and it appears the market has already priced this in. As of the end of June, the MSCI Europe Index had a dividend yield of over 3% and a trailing 12-month price/earnings ratio of around 13 times. On the other hand, the MSCI USA Index had a dividend yield of just under 2% and a trailing 12-month P/E of around 17 times. Europe is home to many multinationals with established operations in the faster-growing emerging markets, such as  Nestle (NSRGY) and  HSBC (HBC), so current valuations may seem relatively attractive for an investor with a long-term horizon.

While emerging markets have a more attractive long-term growth outlook, a cap-weighted exposure to emerging markets has its drawbacks. Many of the largest companies in the emerging markets are state-owned companies that may be used to support economic or political goals at the expense of profitability. This is more likely to be the case during this period of slowing growth, particularly in the larger emerging markets such as China, Brazil, and Russia. Emerging markets are also, by definition, less developed and less dynamic, where certain companies or sectors are less able to gain access to capital markets. As a result, a cap-weighted strategy in emerging markets is usually less efficient and less diversified when compared with a cap-weighted strategy in United States equities, where the largest U.S. firms are usually highly successful, well-run companies that are good, long-term investments.

Japan, which accounts for about 15% of this fund, had a stellar start to 2013. New stimulus spending and aggressive quantitative easing helped pushed first-quarter gross domestic product growth to a respectable 3.5% and drove a 30% rally in the Nikkei over the first five months of 2013. However, any sustainable growth in Japan will require structural reforms to address Japan's relatively inefficient labor market and private sector--issues that have long been on lawmakers' agenda with little progress or improvement over the last two decades. In addition, Japan's aging population and massive 200% debt/GDP ratio are two issues that will likely weigh on Japan's growth in the years to come.

VXUS does not hedge its currency exposure, so its returns reflect both asset price changes and changes in exchange rates between the U.S. dollar and other currencies. During periods of high volatility in the global markets, the U.S. dollar tends to rise, which would weigh on the short-term returns of this fund. But over the long term, currency volatility comprises only a small portion of the total risk of an international equity portfolio.

Portfolio Construction
As of June 3, 2013, this fund ceased tracking the MSCI ACWI ex-US IMI Index and began tracking the FTSE Global All Cap ex US Index. Vanguard first announced its plans to transition the benchmarks of 22 index funds (including VXUS) in October 2012 in an effort to save on licensing fees.

This fund's current and previous benchmarks are essentially the same. The FTSE index of about 5,400 securities represents almost 98% of the world's (outside the U.S.) total investable stock capitalization, adjusted to reflect restricted shareholdings and foreign ownership. The MSCI index includes almost 6,000 securities, covering approximately 99%.

A portion of this fund's dividends will not be qualified, as the U.S. has different tax agreements with different countries. Over the past two years, about 70% of VXUS' dividends were considered qualified. In addition, some of the dividends are subject to foreign tax withholding. Investors can claim their portion of the withheld taxes as a tax credit but only if they hold this fund in a taxable account.

Fees
With an annual fee of 0.16%, this is one of the most inexpensive funds available for broad exposure to foreign equities. Vanguard employs fair-value pricing for its international equity funds, which means it adjusts its net asset value to reflect market events that have occurred since the close of foreign markets. There is no adjustment made to the benchmark index, so this ETF's performance can deviate from that of its underlying index to a greater degree than if it did not employ fair value pricing. As a result, VXUS should trade at lower premiums and discounts to its net asset value relative to ETFs that do not employ fair value pricing.

Alternatives
Vanguard's family of international equity ETFs now all track FTSE indexes, so investors interested in managing their international allocations may want to consider these funds. They include  Vanguard FTSE Developed Markets (VEA) (expense ratio 0.10%),  Vanguard FTSE Emerging Markets (VWO) (0.18%),  Vanguard FTSE Europe (VGK) (0.12%),  Vanguard FTSE Pacific (VPL) (0.12%), and large- and mid-cap  Vanguard FTSE All-World ex-US (VEU) (0.15%) and  Vanguard FTSE All-World ex-US Small Cap (VSS) (0.25%). There is also a total world equity fund:  Vanguard Total World Stock (VT) (0.19%).

Those who want an international fund that tracks an MSCI index can consider iShares Core MSCI Total International Stock (IXUS), which charges 0.16%.

Morningstar has over 50 analyst-rated foreign large-cap funds, which can be found here.

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