The Cheapest Fund for All-Cap, Developed-, and Emerging-Markets Exposure

Vanguard made a bold move in June when it announced that it will be adding onshore-listed China A-shares to the

With a 0.14% expense ratio, Vanguard Total International Stock ETF is a very cheap and efficient way to gain access to international equities. Funds in the foreign large-blend Morningstar Category (which includes actively managed funds) carry a median expense ratio (investor share class) of 1.06%. In fact, this Vanguard Total International Stock ETF is used in Vanguard’s target-date and LifeStrategy allocation funds to cover the entire international-equity allocation. Vanguard does not hold separate international developed- and emerging-markets funds in these allocation funds; instead, it uses this all-in-one fund.

Below is our exchange-traded fund report on Vanguard Total International Stock ETF.

Suitability

Morningstar advises investors to allocate about 15% to 20% in international equities within a diversified stock and bond portfolio. This fund is a one-stop option for international-equity exposure within a diversified portfolio. Those who want more customized exposure can use this fund as a core holding and add on regional or single-country funds.

This exchange-traded fund falls in the foreign large-blend Morningstar Category. Most of the large, actively managed funds in this category have a very small allocation to emerging-markets stocks. However, given that this fund is market-cap-weighted, 20% of its portfolio is invested in emerging-markets equities (including Taiwan and South Korea). This is significantly higher than the category average of 8%. As such, the relative performance of emerging-markets equities can have an impact on this fund's performance relative to its peers in the foreign large-blend category.

This fund does not hedge its currency exposure, so its returns reflect both asset price changes and translation effects when the value of this fund's holdings are converted into U.S. dollars. In the 10-year period through December 2012, a rising euro, followed by a rising yen (against the U.S. dollar), helped boost the performance of this fund. However, more recently, the rising dollar has hurt the fund's performance.

Fundamental View This fund is dominated by blue-chip multinationals, which during the past few years have benefited from improving productivity, cheap financing, and exposure to faster-growing emerging markets. Most of these firms are in good financial shape. However, now that the U.S. Federal Reserve's quantitative-easing program has ended, there is uncertainty as to how monetary policy will be managed and how it might ultimately affect global asset prices--especially considering that valuations across most major asset classes appear to be somewhat stretched.

In Europe, the macroeconomic environment continues to be weak, with near-zero gross domestic product growth, 10%-plus unemployment, deflationary pressures, and ongoing deleveraging in the banking sector. At this time, the European Central Bank is doing whatever it can to preserve the European Union and prevent the eurozone from going into a deflationary spiral. During the past few years, European equities, as measured by the MSCI Europe Index, have recovered from 2012 lows. However, this rally was muted for investors in this fund because of the falling euro against the U.S. dollar. The MSCI Europe Index, in U.S. dollars, returned 7.6% in the two-year period through July 2015; in local currencies, the index returned 13.2%.

After two "lost decades," Japan's equity markets responded very enthusiastically to Prime Minister Shinzo Abe's programs to jump-start the Japanese economy. At the start of 2013, Japan's Central Bank unleashed an aggressive monetary easing program. This move provided the foundation for improving macroeconomic fundamentals and corporate earnings growth. Dividend payout ratios and buybacks are on the rise, as are returns on equity. Japanese equities may also benefit as Japan's $1.2 trillion public pension raises allocations in domestic equities and away from low-yielding government bonds. However, any sustainable economic growth in Japan will require structural reforms to address Japan's inefficient labor market and protected private sector. These issues have long been on lawmakers' agendas, and there has been little progress or improvement on these fronts during the past two decades because of strong, entrenched interests. In addition, Japan's aging population and massive 200% debt/GDP ratio are two issues that likely will weigh on Japan's growth in the years to come.

In the emerging markets, the tailwinds from a decade of strong gross domestic product growth and stellar equity market performance have faded. Foreign fund flows have grown more fickle, and countries with relatively weaker fundamentals have experienced higher currency and local stock market volatility. Many emerging-markets countries need to make difficult changes to avoid the middle-income trap and are settling into a period of slower GDP growth in the medium term. By region, Asia appears to be a relative bright spot. Growth in 2015 and 2016 is estimated at around 6%, as emerging Asia benefits from cheaper commodity imports and still-accommodative financial conditions. In contrast, weak commodity markets will likely continue to have a negative impact on Latin America; Brazil is expected to see its economy contract by about 1% in 2015.

Portfolio Construction As of June 3, 2013, this fund ceased tracking the MSCI ACWI ex USA 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 5,600 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. During 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. Top exposures by currency include the euro (20%), the Japanese yen (17%), and the British pound sterling (15%).

Fees With an annual fee of 0.14%, this is one of the cheapest funds available for broad exposure to foreign equities. The SEC requires fund companies to employ fair value pricing for foreign-equity mutual funds (but not ETFs). Because this fund is the ETF share class of the Vanguard Total International Stock mutual fund, Vanguard applies fair value pricing to VXUS' net asset value. This means it adjusts the fund's NAV to reflect market events that have occurred since the close of foreign markets. This is to ensure that the fund's NAV reflects true value and to minimize arbitrage opportunities for market-timers. There is no adjustment made to the fund's underlying index, so on a day with high market volatility, the fund's NAV may deviate slightly from its index. This difference usually corrects itself when foreign markets reopen. Long-term investors should not be affected by these very small, short-term discrepancies.

Alternatives

Vanguard's family of international-equity ETFs now all track FTSE indexes, so investors interested in managing their regional allocations can consider using these funds. They include

Those who want a similar fund that tracks an MSCI index can consider

Regarding actively managed funds, a list of international-equity large-cap Morningstar Medalists can be found here.

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