A Dynamic Approach to Value Investing Abroad

Investors who want to overweight value stocks in the United States have plenty of cheap options to do so. Unfortunately, investors have to pay up more for a value tilt in foreign developed markets. The only major market-cap-weighted value index fund in the foreign large-value Morningstar Category,  iShares MSCI EAFE Value (EFV), charges 0.40%, significantly more than Vanguard FTSE Developed Markets (VEA) (0.10%). Schwab Fundamental International Large Company (FNDF) is slightly cheaper (0.32% expense ratio). This exchange-traded fund introduces a value tilt with an unconventional approach.

Rather than weighting its holdings according to market capitalization, as most indexes do, Schwab Fundamental International Large Company weights its holdings based on fundamental measures of size. These include average sales (adjusted for leverage), retained operating cash flow, and dividends plus share buybacks over the past five years. This approach causes the fund to overweight cheaper stocks and underweight the more expensive ones relative to a market-cap-weighted index. For example, if two stocks generate the same dollar value of sales, but one trades at a higher valuation than the other, it would receive a greater weighting in a market-cap-weighted index. In contrast, a fundamental index fund would assign the same weighting to these stocks, holding other factors constant.

Because valuations influence market capitalizations, market-cap-weighting can reduce a fund's exposure to stocks as they become cheaper and increase its exposure to those that become more expensive. Fundamental weighting breaks with this tradition. Instead, it attempts to replicate an active manager's strategy of adding to positions that become cheaper and trimming positions as they become more expensive relative to other stocks when it rebalances. This approach may help the fund more effectively profit from mean reversion in valuations than market-cap-weighted value funds, like iShares MSCI EAFE Value. However, it can also increase exposure to stocks with deteriorating fundamentals because accounting metrics are usually slower to pick that up than market prices.

Schwab Fundamental International Large Company also differs from iShares MSCI EAFE Value because it does not specifically target the cheaper half of foreign developed markets. Rather, it offers broad exposure to large-cap stocks in the Russell Fundamental Global Developed ex-U.S. Index, which may improve diversification.

From its back-filled inception in June 1996 through October 2014, the Russell Fundamental Developed ex-U.S. Large Company Index--the fund's benchmark--outpaced the MSCI EAFE Value Index by 2.6% annualized, with comparable volatility. The relative wealth chart below illustrates the timing and magnitude of this outperformance. When the line is sloping up, the Russell Fundamental Developed ex-U.S. Large Company Index is outperforming. The opposite is true when it sloping down. While there were multiyear spans when the fundamental index did not generate superior performance, it appears to have worked well over the long run.

 Source: Morningstar.

A dose of skepticism is in order. With the benefit of hindsight, anyone can create an impressive looking back-test. But it is more difficult to assess how the strategy will fare in the future. Schwab Fundamental International Large Company has only been around for a little more than a year, so it's too soon to assess its live performance record. PowerShares FTSE RAFI Developed Markets ex-U.S. (PXF) launched earlier (in June 2007) and applies a similar fundamental weighting strategy. However, it does not adjust sales for leverage or include share buybacks in its measurement of dividends. It also adds book value to the mix.

Rebalancing frequency is a more important difference. Where the PowerShares fund concentrates its entire turnover on one day of the year, the Schwab fund divides its portfolio into four equal slices and rebalances each slice once a year on a rolling quarterly basis. This approach helps reduce the market-impact cost of trading. Despite these differences, the two funds' benchmarks are highly correlated. PXF outpaced iShares MSCI EAFE Value by 1.1% annualized from its inception through October 2014. This should give investors greater confidence that fundamental indexing abroad can work in practice.

Even if Schwab Fundamental International Large Company's return advantage relative to the MSCI EAFE Value Index is smaller going forward, its value tilt will likely continue to pay off. Value stocks have historically outpaced their more expensive growth counterparts in nearly every market studied over long time horizons. Investors may extrapolate recent growth too far into the future, which can push prices away from fair value. Fundamental weighting counters this bias by removing the link between market prices and portfolio weights.

Fundamental View
In his paper, "Why Fundamental Indexation Might--or Might Not--Work," Morningstar's Paul Kaplan observed that fundamental indexes make the implicit assumption that all holdings should trade at the same fair value multiples. But some stocks clearly deserve higher valuations than others, because of better growth, less risk, or more valuable assets. Market-cap indexes incorporate this information into their portfolio weightings. Yet--as the proponents of fundamental indexing argue--market prices are noisy and may diverge from fair value. Kaplan asserts that in order for a fundamental index to be superior to a market-cap index, market valuation errors would need to be more variable than differences in the justified fair value multiples. This may be a fair assumption for stocks at the extremes of the valuation spectrum (deep value and high growth).

Market prices don't need to be wrong for fundamental indexing to offer a return advantage. The market may correctly assign lower valuations to riskier stocks so that they offer higher expected returns as compensation. Fundamental indexes may collect a risk premium for overweighting these stocks. While we do not know for sure whether risk or mispricing is responsible, the undeniable fact is that value stocks have historically outpaced the market over the long run. Because the fund gives an overweighting to these stocks, it should follow a similar return pattern.

There is nothing special about the weightings that fundamental indexes employ. In a provocative paper titled, "The Surprising Alpha From Malkiel's Monkey and Upside-Down Strategies," Rob Arnott and his colleagues found that many non-market-cap-weighted strategies, including fundamental weighting, outperformed the market-cap-weighted benchmark. They then flipped the weightings of these portfolios around so that the smallest constituents received the largest weightings. These inverse portfolios also outperformed the market-cap benchmark and, in many cases, the original strategies. The authors argue that the success of both the original strategies and their inverses is due to their implicit tilts toward small-cap and value stocks.

Risk and Valuations
Economic conditions in many foreign developed markets aren't great. In order to stimulate growth, the European Central Bank implemented a negative target deposit rate. The Bank of Japan is also in easing mode. Last week, it announced a massive expansion in asset purchases in an effort to boost inflation and growth. In contrast, the Federal Reserve recently announced that it is ending its quantitative easing program in response to improving economic fundamentals in the U.S. If the European Central Bank and Bank of Japan continue to ease, while the Fed pulls back, it could cause the dollar to strengthen against the yen and euro. This could hurt the fund's performance because slightly more than half of its assets are denominated in these two currencies, and it does not hedge its currency exposure.

While they may expose investors to greater risk, foreign developed-markets stocks are trading at lower valuations than U.S. stocks. At the end of October, Schwab Fundamental International Large Company's holdings were trading at 14.3 times forward earnings and 1.3 times book value. The corresponding values for Schwab Fundamental U.S. Large Company ETF (FNDX) were 16.2 and 2.3, respectively.

 

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