An Attractive European Stock ETF

Developed European market stocks account for about a fifth of the world's investable market capitalization. Therefore, they should carry a meaningful weighting in a globally diversified portfolio. Investors who own broadly diversified international-stock funds may already have significant exposure to European stocks. But this could serve as a core holding for those looking to increase their exposure to this region. Most of the fund’s largest holdings are multinational firms with global operations such as

Many of the fund’s sector and country weightings are similar to the U.S. open-end Europe-stock category average. However, it has greater exposure to financial services stocks and a little less exposure to the technology sector. Stocks listed in the United Kingdom and Switzerland account for 44% of the portfolio. Most of the remaining assets are invested in stocks listed in the eurozone, giving the fund significant exposure to fluctuations in the value of the euro. Like most of its peers, the fund does not hedge its currency risk. Currency fluctuations tend to make the fund more volatile than broad U.S. stock indexes.

The fund hasn't stood out on performance during the trailing 10-year period through August 2016. During that time, it lagged the average return of its surviving mutual fund peers by 64 basis points annualized, with comparable volatility. Including nonsurviving funds, that underperformance fell to 10 basis points. Despite its middling performance, low fees should give the fund an edge over the long term.

Fundamental View Britain's decision to leave the European Union has created uncertainty about the future of its relationship and commercial trade with the bloc. This potential fallout from the exit could slow new investment and weaken demand, potentially hurting the fund's holdings.

Elevated macroeconomic risk is not new to investors in European stocks. In the aftermath of the global financial crisis, the region was reeling from a sovereign debt crisis and weak demand stemming from austerity measures to bring debt under control. These events are difficult to predict, and once they occur it is often too late to take corrective action. But uncertainty does not necessarily mean that it is prudent to avoid European stocks. They should be priced to offer competitive compensation for their risk.

The European Central Bank has pursued aggressive monetary policy to keep interest rates ultralow and stimulate demand. Low interest rates can spur demand by making it cheaper to borrow to finance consumption and investment. They also help prop up asset prices. While interest rates must almost certainly rise in the future, they will likely remain low in the near term.

About 45% of the fund’s assets are invested in stocks listed in the eurozone. It also has significant exposure to British stocks, which account for nearly 31% of the portfolio. But the countries where the fund’s holdings are listed are not necessarily indicative of the portfolio’s economic exposure. While most of these firms do a lot of business in Europe, the largest holdings tend to have global operations, just like most large U.S. stocks.

Market-cap weighting skews the portfolio toward the largest stocks in Europe, such as

Many of the fund’s holdings do not enjoy durable competitive advantages. Of the holdings Morningstar equity analysts cover, 30% by market value carried a Morningstar Economic Moat Rating of None at the end of July 2016, which was comparable to the category average. Competition will likely limit these firms’ profitability.

Although considerable risks remain, the fund’s holdings are trading at lower valuations than their U.S. counterparts. At the end of August, the constituents in the fund’s benchmark were trading at a lower average price/forward earnings multiple (16.6) than those in the Russell 3000 Index (19.5), like most of its category peers. And they offered a higher average estimated dividend yield.

Portfolio Construction In October 2015, Vanguard transitioned the fund from the FTSE Developed Europe Index to the FTSE Developed Europe All Cap Index, which extended the fund's reach to include small-cap stocks. This index includes large-, mid-, and small-cap stocks listed in developed European countries, including Switzerland and the U.K.

FTSE ranks all stocks in the region by free-float-adjusted market cap and excludes those representing the smallest 2% of the market to define the investable universe. The all-cap index targets stocks representing the largest 98% of the remaining universe by market cap. However, FTSE allows existing constituents that drop slightly below that threshold to stay in the index to reduce turnover. Qualifying stocks must also meet minimum liquidity requirements. The index weights its holdings by float-adjusted market cap and reconstitutes semiannually in March and September. This weighting approach keeps turnover low and tilts the portfolio toward the largest stocks. The fund applies near full index replication, which should keep tracking error low.

Fees This is one of the cheapest funds in its category. It charges a razor-thin 0.12% expense ratio. It also offers good liquidity, which should make it cheap to trade. Vanguard engages in securities lending, the practice of lending out the fund's underlying holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses.

Alternatives Investors attracted to VGK's broad coverage of the European market might also consider iShares Core MSCI Europe IEUR, which charges the same 0.12% expense ratio. It offers market-cap-weighted exposure to large-, mid-, and small-cap stocks in most of the countries VGK covers. More than 95% of the assets in their portfolios overlap. But VGK has a larger asset base and more fully replicates its index than IEUR.

Investors looking for pure exposure to stocks listed in the eurozone might consider

A currency-hedged fund, such as

A small-cap European fund, such as WisdomTree Europe SmallCap Dividend ETF DFE (0.58% expense ratio), may offer cleaner exposure to the European economy. This fund invests in dividend-paying small-cap European stocks and weights its holdings by dividends, similar to HEDJ.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.