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ETFs

Get Diversified Exposure to Europe at a Bargain Price

Vanguard FTSE Europe ETF is one of the cheapest and best-diversified funds in the category, but performance has been middling.

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The exchange-traded fund transitioned to the FTSE Developed Europe All Cap Index from the FTSE Developed Europe Index in October 2015, which extended its reach to include small-cap stocks. This well-diversified portfolio includes over 1,100 stocks listed in 15 developed European countries, covering 98% of the investable market. It currently only parks 16% of its assets in its top 10 holdings. Market-cap weighting tilts the portfolio toward the largest companies in Europe, such as Nestle, BP, and HSBC, while keeping turnover low. Many of these companies have global operations, which makes their listing country less significant.

The fund's country composition is similar to its peers' with about half of assets allocated to eurozone countries. Differences are limited to a slight bias toward companies from the United Kingdom and Switzerland. The portfolio's sector composition is also similar to the category average, and both have about a 20% stake in the financial-services sector. Given these similarities, this fund should perform similar to the category norm, gross of fees. But its sizable cost advantage should give it an edge.

So far, performance has been lackluster. Over the trailing five-, 10-, and 15-year periods through March 2017, the fund slightly lagged the category average return but performed in line with its index peers. Like many of its peers the fund does not hedge its currency risk.

Vanguard recently cut the fund's expense ratio to 10 basis points from 12, making it one of the cheapest funds in its category. Its tracking error was a little high over the trailing 12 months through March 2017. This was partially due to fair value pricing and deviations between the portfolio and the index that may have occurred because of differences in transaction timing as the managers sought to mitigate transaction costs. Over long periods, these small differences should wash out.

Fundamental View European stocks can help diversify a portfolio of U.S. stocks. Although many of the fund's holdings are global organizations, they tend to be more sensitive to market conditions in Europe and can help diversify interest-rate and market risk. The sector composition of the European stock market is also quite different from the United States. The fund has greater exposure to the basic-materials and consumer staples sectors than the Russell 3000 Index, and less exposure to technology stocks. That said, the correlation between the FTSE Developed Europe All Cap Index and Russell 3000 indexes was fairly high (0.89) over the trailing 10 years through March 2017.

This portfolio is broadly diversified across large-, mid-, and small-cap companies in Europe. Because of its market-cap-weighting approach, the fund has a larger average market capitalization than the Europe-stock category norm. Market-cap weighting reflects the market's view of each stock's relative value and reduces exposure to stocks as they become smaller and cheaper, which may have higher expected returns. However, it tilts the portfolio toward better-established and less-volatile stocks. It also promotes low turnover, which helps minimize transaction costs.

Large multinational firms also have the benefit of global operations and diversified revenue streams. This mitigates the impact that the local economy will have on these businesses. However, European stocks have struggled to keep pace with U.S. stocks following the 2008 to 2009 global recession. From March 2009 through March 2017, the FTSE Developed Europe All Cap Index returned 11.6% annually while the Russell 3000 returned 18.2%.

Over this period, the European Central Bank, Bank of England, and Swiss National Bank engaged in aggressive monetary policies to stimulate economic growth. Central banks cut interest rates to lower the cost of borrowing money, which should encourage investment and promote growth. But Europe has been plagued with macroeconomic risk, most notably the U.K.'s decision to leave the European Union and tepid demand growth. As a result, European stocks tend to be less profitable and trade at lower valuations than U.S. stocks.

Because the fund does not hedge its currency risk, it has significant exposure to the pound, euro, and Swiss franc. The euro represents the fund's largest currency exposure. Stocks denominated in this currency represent 46% of the portfolio. Many European currencies have declined against the U.S. dollar over the past few years, hurting the fund's performance. Stock returns denominated in local currencies from the U.K., Switzerland, and the eurozone outpaced returns denominated in U.S. dollars.

Portfolio Construction This fund tracks a broad market-cap-weighted index of stocks from 15 developed European countries. It effectively diversifies risk and promotes low turnover, earning a Positive Process Pillar rating. Vanguard transitioned the fund from the FTSE Developed Europe Index to the broader FTSE Developed Europe All Cap Index in October 2015. This switch expanded the fund's reach to include small-cap stocks.

The all-cap index includes stocks representing the largest 98% of the European market by market capitalization. Its market-cap-weighting approach emphasizes the largest and most established firms, while keeping turnover low. The index is reconstituted semiannually in March and September, and holdings are subject to buffer rules around the cutoff point to reduce turnover. Qualifying stocks must also meet liquidity requirements to make the index easier to track and to mitigate transaction costs.

The fund employs near-full replication to track its benchmark. It includes Switzerland and the U.K., which together made up 43% of the portfolio as of this writing. Stocks from eurozone countries accounted for an additional 46% of the fund's holdings.

Fees Vanguard recently cut the fund's expense ratio to 10 basis points from 12, making it one of the cheapest funds in the Europe-stock category and earning a Positive Price Pillar rating. The fund builds on this cost advantage through low turnover, which helps hold down transaction costs. This was last reported at 6 percentage points, landing in the lowest decile of the category.

The fund has not made any capital gains distributions in the last decade. It is allowed to engage in securities lending, the practice of lending out the underlying holdings in exchange for a fee. Vanguard returns all profits from this activity to shareholders, which can help offset the expense ratio.

Alternatives

Pure exposure to eurozone-listed stocks is available with

Investors interested in a fund that hedges out currency risk might consider

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