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ETF Specialist

An Extensive Developed-Markets Fund

Diversification and low fees are a compelling combination.

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Foreign stocks are a great way to diversify a U.S.-focused portfolio as they provide access to a wider opportunity set and don't always move in the same direction as the U.S. market. A broad foreign developed-markets fund, like Vanguard FTSE Developed Markets ETF (VEA), captures a majority of the overseas market while diversifying across a wide range of countries and currencies. VEA further builds on its diversification benefits by including small-cap stocks. Its low fee and outstanding index-tracking performance add to its appeal and underscore its Morningstar Analyst Rating of Silver.

VEA tracks the FTSE Developed All Cap ex US Index, which covers stocks of all sizes from 23 foreign developed markets, including Canada and South Korea. It weights its holdings by market capitalization, an approach that benefits investors by capturing the market's consensus opinion of each stock's value while mitigating turnover. Markets usually get long-term prices correct, but they occasionally make mistakes. Investors can drive valuations up if they get excited about a particular area of the market, and market-cap-weighting will increase the fund's exposure to it.

Broad diversification mitigates the impact of the worst performers on the fund's overall performance. The target index covers more than 3,800 stocks, and its 10 largest holdings account for only 9% of assets.

Non-U.S. stock funds like this one can diversify a U.S. stock portfolio by providing access to a wider opportunity set. The portfolio's sector weightings are comparable to its average Morningstar Category peer. It does not hold stocks from emerging markets, while a typical competitor has a 7% stake. This modest difference shouldn't impact the fund's category-relative performance.

The fund's total and risk-adjusted returns were similar to the category average from its launch in July 2007 to November 2018. It remains fully invested, while its better-performing competitors were more defensive, giving them an advantage over this period of lackluster market performance. The fund's 0.05% expense ratio is a sizable cost advantage over most of its competitors and should provide a long-term durable advantage. In a stronger market environment, its smaller cash balance should help its category-relative performance.

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 roughly 80% of the available foreign market cap. 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, Royal Dutch Shell, and Toyota rank among its top holdings.

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 floats with its price changes and requires very little turnover to maintain its desired exposures. Low turnover translates into low transaction costs. 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.

International corporations have global operations and diversified revenue streams, much like their large-cap counterparts listed in the United States. Therefore, they don't provide clean access to the economies where they are headquartered. But this fund also includes small-cap stocks. Smaller firms tend to derive a larger portion of their revenue from their local economies than multinational corporations and therefore can improve diversification.

The fund's market-cap-weighted approach also diversifies 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 20% of the portfolio. Stocks from eurozone countries account for 25% of the fund's assets, while Japan and the United Kingdom make up an additional 23% and 14%, 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 a well-diversified index of stocks from foreign developed markets. Its market-cap-weighted approach taps into the market's collective wisdom regarding each stock's relative value, supporting a Positive Process Pillar rating.

The managers use full replication to track the FTSE Developed All Cap ex US Index, which starts with stocks of all sizes listed in 23 foreign developed countries. It sorts this large cohort by their free-float-adjusted market cap and holds those that rank in the top 98% by market cap. The index uses buffering rules around the cutoff point to help mitigate turnover. It also applies liquidity screens to ensure that the index is investable. The index weights its final holdings by market cap, which mitigates turnover and the related trading costs. The index reconstitutes semiannually in March and September.

Fees
Vanguard offers this fund through two low-cost share classes, supporting its Positive Price Pillar rating. In November 2018, the firm closed Vanguard Developed Markets Index's Investor share class ((VDVIX)) and lowered the investment minimum on the Admiral share class ((VTMGX)) to $3,000 from $10,000 ($3,000 was the minimum for the outgoing Investor share class). The Admiral shares charge 0.07%, while the exchange-traded fund's fee is 0.05%. Both expense ratios rank among the lowest in the foreign large-blend category. The ETF lagged the fund's target index by 8 basis points annually over the trailing three years through November 2018--an amount comparable to its expenses.

Alternatives
Silver-rated SPDR Portfolio Developed World ex-US ETF (SPDW) (0.04% expense ratio) is a close competitor that also invests in stocks of all sizes from foreign developed markets, including Canada and South Korea. It weights holdings by market cap, but the managers use a statistical sampling approach to further reduce trading costs.

Vanguard Total International Stock ETF (VXUS) (0.09% expense ratio) and iShares Core MSCI Total International Stock ETF (IXUS) (0.09% expense ratio) are similar market-cap-weighted funds that cover the broader foreign-stock market. But both of these funds improve diversification over VEA by including stocks from emerging markets and earn Gold ratings.

Currency-hedged funds can damp the additional currency risk that comes with foreign investments. Bronze-rated iShares Currency Hedged MSCI EAFE ETF (HEFA) (0.34% expense ratio) tracks the large- and mid-cap-focused MSCI EAFE Index, and the managers use forward contracts to hedge foreign-exchange risk. This is an effective way to eliminate currency risk, but it is less tax-efficient than an unhedged portfolio.

Risk-averse investors who don't want the tax burden that comes with currency hedging might consider Silver-rated iShares Edge MSCI Minimum Volatility EAFE ETF (EFAV) (0.20% expense ratio). It uses an optimizer to build the least volatile portfolio possible from foreign developed-markets stocks in the MSCI EAFE Index under a set of constraints. These include keeping country and sector weightings within 5% of the index to promote diversification and capping turnover at 20%.

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