Take Advantage of Mean-Reverting Prices With This Foreign Value ETF

Foreign value exchange-traded funds are in short supply. To make matters more difficult, the few funds that are available tend to overweight stocks from certain sectors, like financials, which compromises their diversification. Schwab Fundamental International Large Company Index ETF FNDF, with a Morningstar Analyst Rating of Bronze, has something to offer. It holds both value and growth stocks but tilts toward those trading at lower valuations than the market. This a well-diversified value strategy that can take advantage of mean-reverting prices wherever they occur.

This fund tracks the Russell RAFI Developed ex-U.S. Large Company Index. It targets large- and mid-cap stocks from overseas developed markets and weights its holdings based on sales (adjusted for leverage), retained operating cash flow, and dividends plus buybacks. When the fund rebalances, it will increase its exposure to stocks that have become cheaper relative to these metrics and underweight those that have become more expensive.

This approach has some advantages. Steering the portfolio away from the most expensive stocks can help performance if and when valuations mean-revert--but there is a trade-off. Ignoring prices means the fund can overweight stocks with declining fundamentals, which can add to its risk.

The index calculates each stock’s fundamental weight annually in March, but it rebalances a different fourth of its portfolio each quarter. Breaking up the rebalancing trades in this way helps reduce the risk of poorly timed rebalances and the market impact costs of trading.

While the fund includes growth stocks, they do not detract from the fund’s value orientation because it owns less of them than a style-neutral benchmark like the FTSE Developed Ex-U.S. Index. This benefits investors because it helps diversify stock-specific risk. The fund doesn’t constrain country or sector weightings, so it can see some country or sector biases relative to the FTSE Developed Ex-U.S. Index.

This strategy has shown some potential over short stretches, but it has not yet provided a long-term advantage over the FTSE Developed ex-U.S. Index. Its total and risk-adjusted returns were similar to this benchmark from its launch in August 2013 through May 2019. The fund’s 0.25% expense ratio helped it outperform a majority of its Morningstar Category peers and should continue to provide an edge.

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 2019. Most of the time, their performance has been similar.

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. It holds about 950 stocks, while the cap-weighted index holds a little more than 500. Its 10 largest holdings account for 13% of assets, compared with 17% for the cap-weighted benchmark.

The fund's dynamic rebalancing approach also sets it apart from its competitors. To rebalance back to its fundamental weightings, 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 mildly 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 weightings, 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 28% of this fund, while those from Japan and the U.K. make up an additional 25% and 15% 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's well-diversified fundamental weighting approach takes advantage of mean-reversion across the entire spectrum of large-cap stocks. It earns a Positive Process Pillar rating.

The managers use near full replication to track the Russell RAFI Developed ex-U.S. Large Company Index. The selection process starts with all stocks in the FTSE Global Total Cap Index, subject to some liquidity screens. Each company is then ranked and weighted according to three fundamental measures: 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 score. 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-U.S. Large Company Index then targets stocks from this index that are listed in foreign developed markets. The index weights its holdings based on the previously calculated fundamental scores, and it caps these weights so that the portfolio only holds a small fraction of a stock’s publicly available shares.

The index reconstitutes annually in March, but it executes any changes across four equal rebalancing events in March, June, September, and December. Dividing the rebalancing activity in this way helps reduce the risk of poor timing and market impact costs that can result from a single annual rebalance.

Fees This fund's low fee earns a Positive Price Pillar rating. Schwab charges 0.25% annually, making this fund one of the lowest-cost value strategies in the foreign large-value category. Despite using a fundamental weighting approach, the portfolio's turnover ratio has also run lower than many of its category peers, which helps mitigate transaction costs. The fund lagged its target index by 8 basis points annually over the trailing five years through May 2019--an amount less than its expense ratio. Conservative tax withholding assumptions embedded in the fund's target index and securities-lending revenue contributed to this modest advantage.

Alternatives Bronze-rated Invesco FTSE RAFI Developed Markets ex-U.S. ETF PXF is a close alternative to FNDF, but its higher 0.45% expense ratio makes it a less appealing option. PXF uses different fundamental metrics to weight its holdings, including total sales, free cash flow, total cash dividends, and book value. But these differences shouldn't cause PXF to deviate too much from FNDF. However, PXF reconstitutes its portfolio once every year in March, which can increase market impact costs relative to FNDF.

A market-cap-weighted value index fund, such as iShares MSCI EAFE Value EFV (0.40% 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 capitalization and strength of value orientation.