A Well-Diversified Foreign-Stock Fund With a Value Tilt

Investors in search of foreign-value exchange-traded funds currently face a limited menu. To make matters more difficult, the few funds on offer tend to overweight stocks from certain sectors, like financials, which compromises their diversification.

FNDF is a solid low-cost fund that weights its holdings by fundamental measures of size, giving it a value orientation. While it maintains diversification, it can be a risky because it ignores market prices and can overweight stocks with declining fundamentals, warranting a Morningstar Analyst Rating of Bronze.

The portfolio targets large- and mid-cap stocks from developed-markets countries and weights its holdings based on sales (adjusted for leverage), retained operating cash flow, and dividends plus buybacks. When the fund rebalances, it increases its exposure to stocks that have become cheaper relative to these metrics and cuts back on its exposure to those that have become more expensive. This contrarian approach introduces a value tilt to the portfolio, and its price/book ratio is in line with the MSCI World ex USA Value Index. The fund's index calculates each stock's fundamental size annually, but the fund rebalances a different fourth of its portfolio each quarter. Breaking up the rebalancing should be an improvement over a single annual rebalance because it helps reduce the risk of poorly timed rebalances and reduces the market-impact cost of trading.

This alternative approach can drive differences between the fund and the MSCI World ex USA Value Index. The benchmark has almost 35% of its assets in financial stocks while the fund is closer to 19%, meaning it does a better job of spreading its bets across different industries. Over the past several years, it has also tilted toward materials and energy firms following declines in commodity prices. These firms can be risky because they may not always compensate investors for the additional volatility from their commodity exposure.

Despite these risks, some of these bets have benefited the fund. Its total return beat the MSCI World ex USA Index by 1 percentage point annually and the MSCI World ex USA Value Index by more than 2 percentage points annually from its launch in August 2013 through May 2018. The fund's 0.25% expense ratio should be a long-term advantage as it is one of the cheapest funds in its Morningstar Category.

Fundamental View This is a value strategy that offers exposure to large-cap stocks listed in overseas developed markets. The fund weights holdings by several fundamental measures of size rather than market cap, causing its portfolio to overweight cheaper stocks. On the surface, this fund and the market-cap-weighted MSCI World ex USA Value Index provide a similar value orientation. The average price/book ratios of their holdings were comparable between August 2013 and May 2018. Additionally, the fund's correlation with the cap-weighted benchmark was 0.99 over this period, indicating that they have had similar behavior.

Despite its value orientation, the fund also includes growth stocks. This should improve its reach and allow the fund to take advantage of mean reversion in valuations wherever they occur in the large-cap market segment. Additionally, it diversifies stock-specific risk better than the market-cap-weighted MSCI World ex USA Value Index. FNDF holds more than 800 stocks, while the cap-weighted index holds a little more than 500. Its 10 largest holdings account for 14.0% of assets compared with 17.5% for the index.

The fund's dynamic rebalancing approach also sets it apart from its competitors. To rebalance back to its fundamental weights, the fund buys stocks that have become cheaper relative to their peers and trims positions that have become more expensive. This contrarian rebalancing approach should help the fund when valuations mean-revert and provide an edge over cap-weighted value indexes when valuations become extremely high or low. But this approach to rebalancing has its drawbacks. It ignores information contained in market prices, which can lead to overweighting stocks with declining prices and fundamentals. These actions have made the fund more volatile than the market.

Weighting by fundamental measures rather than market cap could cause turnover to run higher than a comparable market-cap-weighted value index. However, the fund's turnover has historically been lower than the MSCI World ex USA Value Index. Most of its rebalancing activity has been focused on changing the weights of its constituents rather than adding or removing names from the fund.

The fund does not have any constraints on its sector weights, so it can occasionally overweight certain sectors relative to the MSCI World ex USA Value Index. This occurred shortly after oil prices declined in 2014, causing the fund to overweight energy stocks in 2015 and 2016. However, its allocation to stocks from these industries has since returned to a level that is comparable to the cap-weighted benchmark.

Stocks listed in the eurozone account for 30% of this fund, while those from Japan and the United Kingdom make up an additional 23% and 16% of assets, respectively. As a result, it has considerable exposure to the euro, yen, and pound. Changes in the exchange rate between these currencies and the U.S. dollar can add to the fund's volatility.

Portfolio Construction This fund tracks the Russell RAFI Developed ex US Large Company Index, which weights holdings by several fundamental measures rather than market cap. This approach introduces a value tilt to the portfolio and should provide an edge when valuations change. It earns a Positive Process Pillar rating.

The selection process starts with all stocks in the Russell Global Index, subject to some liquidity screens. Each company is then ranked and weighted according to three fundamental measures, including sales (adjusted for leverage), retained operating cash flow, and dividends plus buybacks. The average of these three fundamental weights determines a stock's overall fundamental size. Stocks that represent the largest 87.5% of cumulative fundamental weight of this larger cohort make up the Russell Fundamental Global Large Company Index. The Russell RAFI Developed ex US Large Company Index then targets stocks from this index that are listed in foreign developed markets. Weights are assigned based on fundamental size and are capped so that the portfolio only holds a small portion of a stock's publicly available shares.

The index determines each stock's fundamental size annually in June and implements its rebalancing to these weights across four equal subportfolios at the end of each quarter. By spreading out its rebalancing activity, the fund reduces the risk of poor timing and mitigates market-impact costs that can result from a single annual rebalance.

Fees Schwab charges a 0.25% annual expense ratio for this fund, making it cheaper than 96% of its competitors in the foreign large-value category and worthy of a Positive Price Pillar rating. The fund's total returns over the trailing three years through May 2018 lagged its target index by 7 basis points annually, an amount less than the fees it charged. Securities-lending revenue and conservative foreign tax assumptions allowed the fund to recoup some of its expenses.

Alternatives

Bronze-rated

A market-cap-weighted value index fund, such as iShares MSCI EAFE Value ETF EFV (0.39% expense ratio), may also be a suitable alternative. This fund targets stocks representing the cheaper half of the MSCI EAFE Index, which includes large- and mid-cap stocks from foreign developed markets outside of North America. It does not diversify stock-specific risk as well as FNDF, with 20% of assets in its 10 largest holdings.

IShares Edge MSCI International Value Factor ETF IVLU (0.30% expense ratio) has a modestly deeper value tilt than EFV. It looks for the cheapest stocks within each sector based on their price/book, price/forward earnings, and enterprise value/operating cash flow valuations. The portfolio also keeps its sector weights similar to the MSCI World ex USA Index to limit sector bets, which may not be well rewarded over the long term. It weights its constituents based on their market cap and strength of value orientation.