A Compelling Option for International Small-Cap Exposure

This portfolio of over 3,400 holdings effectively diversifies company-specific risk. Its top 10 holdings account for less than 3% of assets, which is significantly lower than the 20% category average. Stocks domiciled in Canada and the United Kingdom dominate the fund’s top holdings, accounting for 24 of the fund’s top 25 holdings. Sector weightings are comparable to the category average except for industrials, which account for only 18% of this fund’s portfolio compared with 23% for the category average.

From its inception in April 2009 through October 2016, the fund has trailed the category average by 1.13% annualized. Much of this underperformance can be attributed to the fund’s large emerging-markets exposure. These stocks account for nearly one fourth of the fund’s assets, which is significantly higher than the 10% category average. During the 2013 and 2015 calendar years, emerging markets significantly underperformed developed markets, creating a drag on this fund’s performance. However, when emerging markets are strong, such as in 2010, the fund has tended to produce strong performance.

Historically, emerging-markets stocks have tended to exhibit higher volatility than developed markets, but over the trailing five-year period through October 2016, this fund’s volatility has been comparable to the category average, partially because of its well-diversified portfolio.

Fundamental View International small-cap stocks can provide a significant diversification benefit when combined with a U.S.-equity-focused portfolio. Over the trailing 10-year period through October 2016, this fund's index, the FTSE Global Small Cap ex US Index, and the S&P 500 had a correlation of 0.85. Small-cap companies tend to better reflect their local economies, compared with many foreign large-cap multinationals that generate a significant portion of their revenue abroad. Historically, small-cap stocks have also modestly outperformed large caps.

The fund’s market-capitalization-weighting approach promotes low turnover and skews the portfolio toward the larger stocks in the small-cap segment. This weighting approach promotes low turnover. In fact, its turnover ratio is consistently less than half of its category peers, which helps keep transaction costs low. But market-cap-weighting could also increase the fund’s exposure to stocks as they become larger and more expensive and away from firms as they become smaller and cheaper, which may have higher expected returns.

In contrast to this portfolio, the majority of funds in the foreign small/mid-blend Morningstar Category maintain fairly small allocations to Canadian and emerging-markets stocks, which creates some significant differences in country exposure. This fund has nearly 15% of its assets in Canada-domiciled stocks, which is 3 times the category average. It also has a 6% exposure to Taiwan compared with the 1% category average. Inversely, the fund’s allocations to Japan and developed Europe stocks are significantly less than the category average.

Despite these differences, Japan and the United Kingdom still represent two of the fund’s largest single-country exposures, accounting for nearly one fourth of the portfolio. These countries are both dealing with economic headwinds. The U.K.'s recent decision to leave the European Union, along with Japan's aging workforce and tremendous public debt, have the potential to slow new investment and weaken demand. However, these risks should already be reflected in market prices.

While economic risk should already be reflected in market prices, investors should be aware of their currency exposure if these economic events lead to changes in monetary policy. Central banks in the U.K., eurozone, and Japan are all using aggressive monetary policies to keep interest rates low in an effort to simulate demand. If rates in those markets stay low, while rates rise in the U.S., the U.S. dollar could strengthen, which would hurt the fund's performance because it does not hedge its currency exposure.

Portfolio Construction The fund employs a near full-replication approach to track the FTSE Global Small Cap ex US Index. This broad, market-capitalization-weighting index promotes low turnover, effectively diversifies risk, and accurately represents its target market. It warrants a Positive Process Pillar Rating.

FTSE defines the investable universe as all stocks listed in foreign developed and emerging markets. The index then sorts these stocks on free-float-adjusted market capitalization and targets companies smaller than the largest 86% of the market by market capitalization and larger than the smallest 2%. The index applies additional screens for liquidity and foreign ownership eligibility to make it easier to track. This result is an index portfolio of approximately 3,300 constituents. FTSE reconstitutes the index semiannually in March and September. This fund may hold overseas-listed depository receipts in lieu of, or in addition to, the domestic listings of index constituents. As a result, the fund actually has more holdings than its index has constituents.

Vanguard applies a fair value pricing policy, adjusting the fund’s net asset value to reflect up-to-date market information for securities with stale prices. This policy protects shareholders from market-timing arbitragers who may otherwise exploit stale NAVs. Because there is no corresponding adjustment to the index, this can create tracking error over the short term, but long-term performance should closely match the index’s.

Fees This fund's 0.17% expense ratio makes it one of the cheapest in the category and earns it a Positive Price Pillar. In contrast, the category median expense ratio is 1.31%. Over the trailing five-year period through October 2016, the fund has trailed its benchmark by 1 basis point annualized. This is partially due to securities-lending revenue, which helps offset the fund's expenses.

Alternatives Schwab International Small-Cap Equity ETF SCHC offers a similar market-cap-weighted portfolio but focuses only on foreign developed markets, including Canada. Its modestly lower 0.16% expense ratio makes it the cheapest ETF in the foreign small/mid-blend Morningstar Category.

DFA International Small Company DFISX (0.54% expense ratio) offers broad market-cap-weighted exposure to small-cap stocks in foreign developed markets, but it excludes some of the most expensive and least profitable stocks from this group. This approach has earned the fund a Morningstar Analyst Rating of Silver. Because it does not track an index, the managers have the flexibility to trade patiently to reduce transaction costs. This fund is only available to individual investors through a qualified financial advisor or select platform, such as a 401(k).

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