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This Outstanding International Fund Looks Different From Its Peers

Gold-rated Vanguard Total International Stock Index hasn't performed like its category, thanks to its geographic composition.

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Vanguard Total International Stock Index is an outstanding foreign-stock fund. This low-cost portfolio is one of the most comprehensive in the foreign large-blend Morningstar Category, and it employs a low-turnover market-cap-weighted approach that harnesses the market’s collective opinion of each stock’s value, earning a Morningstar Analyst Rating of Gold.

This fund tracks the FTSE Global All Cap ex US Index. It encompasses large-, mid-, and small-cap stocks from more than 40 overseas developed and emerging markets, including more than 6,000 different names. It weights holdings by market capitalization, which promotes low turnover while also tilting toward large multinational corporations. Many of this fund’s holdings have global operations and revenue streams, and therefore don’t provide clean exposure to the economies where they are listed.

A well-diversified foreign stock fund like this one can complement a U.S. stock portfolio by providing access to a wider selection of companies not listed in the U.S. Its diversification benefits also extend to regions and sectors. The fund’s sector weightings are comparable to the average of its category peers, but its geographic composition looks different from many of its competitors. It has roughly 17% of its assets dedicated to stocks from emerging markets, while the category average is closer to 7%. This can drive differences in category-relative returns for short periods but should have a muted impact over the long run. Overweighting stocks from these markets helped the fund outperform the category average in 2016 and 2017.

The fund’s 0.11% expense ratio is a significant advantage over its more expensive active competitors. However, this has not translated into superior category-relative performance, with total and risk-adjusted returns landing near the category midpoint from its launch in April 1996 through June 2018. The fund has persistently overweighted Japanese stocks, which were some of the worst performers over this stretch.

Process Pillar: Positive | Daniel Sotiroff 07/12/2018 This fund tracks a heavily diversified index of stocks listed in developed and emerging markets. Its extensive reach includes stocks of all sizes, and its market-cap-weighted approach taps into the market's collective wisdom regarding each stock's relative value. It earns a Positive Process Pillar rating.

The FTSE Global All-Cap ex-U.S. Index starts with all stocks listed in more than 40 countries across developed and emerging markets. It sorts this wide selection by free-float-adjusted market capitalization and holds those that rank in the top 98% by market capitalization. The index uses buffering rules around the cutoff point to help mitigate turnover, and qualifying stocks are subject to liquidity screens to help ensure that the index is investable. It weights final holdings by market capitalization, which mitigates turnover and the related trading costs. The index is reconstituted semiannually in March and September, and the managers use near full replication to fulfill their index-tracking objective.

The resulting portfolio is one of the most comprehensive in the foreign large-blend Morningstar Category. It includes more than 6,000 stocks, while its 10 largest holdings represent only 8% of assets. For comparison, the corresponding figure for the foreign large-blend category average is 26%. Its market-cap-weighted approach favors large multinational firms like Nestle, Samsung, and HSBC. Since its inception in April 1996, the fund’s turnover ratio has historically landed in the mid-single digits, and rarely exceeds 10%.

Most of the fund’s sector weightings are comparable to the category average. Financial firms account for the fund’s largest sector allocation, representing 20% of the portfolio, while industrials and technology each make up an additional 12%.

Eurozone stocks account for 21% of the portfolio, with those from Japan and the U.K. making up an additional 18% and 12%, respectively. The fund also has a 17% allocation to emerging-markets stocks, more than double the category average. Like most of its peers, the fund does not hedge its currency risk, so it has exposure to the euro, yen, and pound. Changes in the exchange rates between these currencies and the dollar can add to the fund’s volatility.

Performance Pillar: Neutral | Daniel Sotiroff 07/12/2018 The fund's long-term track record and more recent performance have been mediocre, warranting a Neutral Performance Pillar rating. From the fund's launch in April 1996 through June 2018, its total and risk-adjusted return landed near the category midpoint. The fund's higher-than-average exposure to Japanese stocks detracted from performance, as the Japanese market was one of the worst performers over the past two decades.

While the fund’s allocation to Japanese stocks has come down over time, its category-relative performance has failed to improve. The fund’s objective is to track the FTSE Global All Cap ex US Index, so it is always fully invested, while many of its active competitors hold larger cash balances. This can help performance in strong market rallies, but hurt it during market downturns. Foreign stocks produced lackluster returns over the trailing eight years through June 2018, so the fund’s smaller cash balance didn’t significantly help its performance. Its total return was close to the category midpoint over this stretch.

The fund’s stake in emerging-markets stocks has been higher than the category average. Stocks from these regions tend to be riskier than those listed in developed markets and can add to the fund’s volatility. From May 1996 through June 2018 the fund exhibited slightly higher volatility than the category average.

People Pillar: Positive | Daniel Sotiroff 07/12/2018 This fund is overseen by two portfolio managers that are equipped with a global support staff and Vanguard's portfolio management technology. They earn a Positive People Pillar rating.

This fund’s management team not only oversees the portfolio, but also executes trades on a day-to-day basis. The fund is comanaged by Michael Perre and Christine Franquin. Perre is a principal in the Vanguard Equity Index Group and has been with the firm since 1990. Franquin replaced Michelle Louie in November 2017. She is a principal at Vanguard and has been managing portfolios since she joined the firm in 2000. Vanguard’s portfolio management team typically consists of two comanagers on each fund, and these managers rotate to different funds every few years to improve their breadth and depth of expertise. They also have access to Vanguard’s trading desks around the world that enable them to make the most efficient transactions in various global markets. Neither of the named managers owns shares in this fund, but that is not cause for concern.

The managers are compensated with a bonus that factors in the gross, pre-tax performance of the fund relative to its objectives. This includes the manager’s record of tracking a benchmark index over the prior 12 months.

Parent Pillar: Positive | 06/05/2018 The Vanguard Group is the world's biggest provider of open-end funds and its second-biggest provider of exchange-traded funds. Innovative and iconoclastic from its mid-1970s origins, the firm's mutual ownership structure, commitment to low fees, and sensible active and passive investment strategies are hallmarks that support its Positive Parent rating.

Vanguard is committed to serving all investors, not just its own. Indeed, the firm celebrates when its entry into an asset class prompts rivals to lower their fees to remain competitive, as occurred when Vanguard launched index funds in London in 2009 and factor-based strategies in the United States in early 2018.

New CEO Tim Buckley, Vanguard's fourth, faces the challenge of expanding the firm's mission to non-U.S. investors, who currently account for less than a tenth of the firm's $5 trillion in global assets under management. He must also navigate the tension between Vanguard's burgeoning discretionary asset-management business, Personal Advisor Services, and financial advisors who may feel threatened by the firm's efforts to lower the cost of investment advice. Perhaps Vanguard's greatest challenge, though, will be keeping pace with its own growth, especially in overcoming the service problems that have bedeviled the firm the past few years. Vanguard's 2017 implementation of client-experience testing labs should help the firm improve there, too.

Price Pillar: Positive | Daniel Sotiroff 07/12/2018 Vanguard offers this fund through three share classes. Investor shares charge 0.17% while Admiral shares and the ETF both charge 0.11%. All of these expense ratios are among the lowest in the foreign large-blend category, and support a Positive Price Pillar rating. The ETF lagged fund's target index by 13 basis points annually over the trailing three years through June 2018. This gap was comparable to the fund's expenses.

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