Cheap Exposure to Foreign Stocks in Developed Markets

The exchange-traded fund owns more than 3,600 stocks across foreign developed markets and weights them by market capitalization. This approach promotes low turnover and skews the portfolio toward large multinational firms with global operations, such as Nestle, Toyota, and Novartis. Since the fund's inception in 2007, its turnover ratio has averaged 8%, which helps keep transaction costs low. In contrast, the foreign large-blend Morningstar Category's average turnover was greater than 50% in the most recent year.

This fund's country exposure exhibits some notable differences compared with category peers. Stocks listed in Canada and South Korea account for less than 5% of the average portfolio in the category. In contrast, these two countries account for more than 10% of this fund's assets, and names such as Samsung Electronics and Royal Bank of Canada are among the fund's top 20 holdings. Additionally, Japanese stocks currently account for almost 22% of this fund's assets, slightly more than the 18% category average.

A well-diversified portfolio and sizable cost advantage should give this fund an edge over the long term. This advantage helped the fund outperform the category average by 31 basis points annualized from its inception in July 2007 through September 2017. The fund's performance was particularly strong from May 2012 through May 2014, outpacing the category average by 2.40%, partially because of more-favorable stock exposure in the financial-services sector.

Fundamental View Foreign stocks can diversify portfolios that have heavy exposure to U.S. equities. However, this diversification benefit tends to be lower among foreign developed-markets stocks compared with emerging-markets stocks. During the trailing 10-year period through September 2017, the correlation between the S&P 500 and the MSCI World ex USA Index, which also tracks foreign developed markets, was 0.90. During the same period, the correlation between the S&P 500 and the MSCI Emerging Markets Index was 0.80. Although the diversification benefit may not be as great for foreign developed-markets stocks, they have historically exhibited lower volatility than emerging-markets stocks.

This broad market-cap-weighted portfolio reflects the composition of the market and promotes low turnover. And it effectively diversifies company-specific risk. The fund's top 10 holdings account for less than 9% of the portfolio, compared with the category average of more than 25%. Yet its weighting approach could tilt the portfolio toward firms as they become larger and more expensive and away from firms as they become smaller and cheaper, which may have higher expected returns. Market-cap weighting also pulls the portfolio toward large multinationals, so the countries where its holdings are listed are not necessarily indicative of the economic exposure they provide. These companies tend to be more profitable and less volatile than their smaller counterparts.

Most of the fund's sector weightings are similar to the category average. However, it has slightly less exposure to technology companies than the category average. Financial-services companies account for the fund's largest sector allocation at 21% of the portfolio. Large banks such as HSBC Holdings and Commonwealth Bank of Australia are among the fund's top 20 holdings.

Similar to category peers, Japan and the United Kingdom represent the fund's two largest single-country exposures, accounting for nearly 40% 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. Additionally, a large proportion of holdings within these two countries are multinationals (like Toyota and BP) with global operations that diversify economic risk.

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 United States, the U.S. dollar could strengthen, which would hurt the fund's performance because it does not hedge its currency exposure.

Portfolio Construction This broad, market-cap-weighted index promotes low turnover, effectively diversifies risk, and accurately reflects the composition of its target market. These attributes support a Positive Process rating.

The fund tracks the FTSE Developed All Cap ex US Index. The methodology starts with all stocks listed in foreign developed markets, including South Korea and Canada, that pass certain liquidity screens. Those that make the cut are sorted based on their free-float-adjusted market capitalization, and the largest 98% by market cap are included in the index. Buffering rules are used around this cutoff point to reduce unnecessary turnover. The index applies additional screens for foreign ownership eligibility to make it easier to track. FTSE reconstitutes the index semiannually in March and September.

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 is one of the cheapest funds in the foreign large-blend category, supporting a Positive Price rating. The fund charges an annual fee of 0.07%, which is significantly lower than the 1.02% category average. The fund's market-cap-weighted approach keeps turnover in check, which helps mitigate transaction costs.

Alternatives

Investors concerned about the volatility that currency fluctuations can introduce might consider a currency-hedged ETF such as Bronze-rated

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