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ETF Specialist

Cheap, Diversified Exposure to Foreign Developed Markets

Developed-market indexes are less concentrated than they were 30 years ago.

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Foreign developed-market indexes are less concentrated than they have been in decades. Japanese firms have dominated many of these benchmarks over the past 30-plus years. But an extended bout of relatively poor performance from these companies has cut their standing to less than 25% of the FTSE Developed Ex US Index—down from roughly 60% in the early 1990s. So, low-fee developed-market index-trackers are less dependent on a single market and currency, making funds like  Schwab International Equity ETF (SCHF) a solid way to get exposure to stocks from established markets.

SCHF has a well-diversified, cap-weighted portfolio that captures the market’s collective wisdom, and is complemented by one of the lowest expense ratios in the foreign large-blend Morningstar Category. This should give it a reliable advantage over its more expensive competitors, and supports a Morningstar Analyst Rating of Silver.

The fund’s target index, the FTSE Developed Ex US Index, is composed of large- and mid-cap companies from 24 developed markets outside of the United States, including companies listed in Canada and South Korea. FTSE defines large- and mid-cap firms as those that land in the top 86% of the investable universe by market capitalization. Holdings are weighted by their free-float-adjusted market capitalization, which keeps turnover low and mitigates transaction costs.

While the fund is limited to large- and mid-cap names, it still provides effective diversification. It holds more than 1,300 stocks, and its 10 largest names account for only 10% of its assets. The fund excludes companies listed in emerging markets, while a typical competitor has 7% of its assets allocated to companies from developing regions. This modest difference can limit the portfolio’s diversification potential but shouldn’t hurt its long-term category-relative performance.

This fund’s greatest performance advantage is its ultralow expense ratio. Schwab charges only 0.06% annually for this fund. While this ranks as one of the cheapest in the category, it has not translated into superior category-relative performance. From its launch in November 2009 through May 2018 the fund’s total and risk-adjusted returns landed near the midpoint of the category. Foreign markets as a whole have not performed well over the past decade, and many of the fund’s better-performing competitors had more defensive portfolios.

Fundamental View
Investing in foreign stocks can help diversify a U.S.-centric portfolio. The fund's focus on developed-markets stocks means that it captures more than 80% of the available foreign-market capitalization. While it does not include stocks from developing nations, the portfolio is still well diversified across stocks, sectors, countries, and currencies. It includes stocks of all sizes, but market-cap weighting emphasizes the largest firms from developed overseas nations. Major multinational firms like Nestle, Samsung, and Toyota rank among its top holdings.

International corporations have global operations and diversified revenue streams, much like their large-cap counterparts listed in the U.S. Therefore, they don't provide clean access to the economies where they are headquartered. Small-cap stocks tend to be more closely tied to their local economies and can improve diversification, but this fund does not include them.

Market-cap-weighted funds, like this one, provide cost-efficient, diversified exposure to the opportunity set that active managers select from and make no active bets on specific regions, countries, sectors, or individual stocks. Using this technique, a stock’s weighting will float with changes in its price and will require very little turnover to maintain its desired exposures. Market-cap weighting essentially free-rides on the judgment of active investors. The allocation to each stock reflects their collective opinion about its relative value. Low turnover translates into low transaction costs.

A market-cap-weighted approach can also be effective at diversifying sector- and country-specific risks. Despite excluding firms listed in emerging markets, the fund's sector composition closely resembles the category average. Financial firms represent the fund’s largest sector at 21% of the portfolio. Japanese stocks have the largest country weight, making up almost one fourth of the fund.

Stocks from eurozone countries account for 27% of the fund's assets, while Japan and the United Kingdom make up an additional 23% and 16%, respectively. Like many of its peers, this fund does not hedge its currency risk, therefore it has exposure to currencies like the euro, yen, and pound. Changes in the exchange rates between these currencies and the U.S. dollar can add to the fund's volatility.

Portfolio Construction
This fund tracks the FTSE Developed Ex-US Index, a well-diversified index that captures the market’s collective wisdom of each stock’s relative value in a low turnover manner, supporting a Positive Process Pillar Rating.

FTSE sorts companies in the investable universe using their free-float-adjusted market capitalization, and targets firms that fall into the top 86% of each country by market capitalization. Buffers are applied around that threshold to mitigate unnecessary turnover. The final index contains more than 1,500 stocks. But this fund’s management team uses a sampling methodology that reduces the number of holdings in the portfolio to about 1,380. This approach reduces the need to own smaller, less-liquid stocks that can be expensive to trade. The index is reconstituted semiannually in March and September. It makes smaller adjustments during additional quarterly reviews in June and December, such as adding recent IPOs. Additionally, stocks must meet minimum liquidity requirements to stay in the index. This helps keep bid-ask spreads low and contributes to low transaction costs.

Schwab charges only 0.06% annually for this fund, making it one of the cheapest in the foreign large-blend category, and worthy of a Positive Price Pillar rating. This fund’s market-cap-weighted approach adds to its low-cost appeal by mitigating turnover and the related trading costs. Its total returns over the trailing three years through May 2018 managed to beat its target index by 7 basis points annually. This modest advantage stemmed from securities-lending revenue and the statistical sampling approach the fund’s managers employ.

Silver-rated  SPDR Portfolio Developed World ex-US ETF (SPDW) offers similar exposure to stocks from foreign developed markets. Like SCHF, it includes stocks listed in Canada and South Korea, but it has a modest diversification advantage because it includes small-caps. SPDW has the lowest expense ratio in the foreign large-blend category, charging only 4 basis points annually.

 Vanguard FTSE Developed Markets ETF (VEA) has a portfolio that is similar to SPDW. It tracks a cap-weighted index of developed-markets stocks, includes names listed in Canada and South Korea, and includes small-caps. Its 0.07% expense ratio is competitive with SCHF and SPDW and the fund also carries a Silver Analyst Rating.

Investors who want to exposure to foreign stocks without the additional foreign exchange risk may want to consider Bronze-rated  iShares Currency Hedged MSCI EAFE ETF (HEFA) (0.35% expense ratio). It tracks a market-cap-weighted index of stocks from 21 foreign developed countries, and the managers use monthly forward contracts to hedge away currency risk.

A more comprehensive portfolio of foreign stocks is available with  Vanguard Total International Stock ETF (VXUS) (0.11% expense ratio) or  iShares Core MSCI Total International Stock ETF (IXUS) (0.10% expense ratio). Both of these funds cover thousands of stocks from more than 40 overseas markets, including emerging economies. VXUS and IXUS both have Gold ratings.

Daniel Sotiroff has a position in the following securities mentioned above: VEA. Find out about Morningstar’s editorial policies.