Low-cost diversified exposure to foreign developed markets

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 stocks has cut their standing to about 25% of foreign developed market indexes--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 great way to get exposure to these established markets. SCHF earns a Morningstar Analyst Rating of Silver.

The fund’s target index, the FTSE Developed Ex U.S. 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. It weights its holdings by market cap, 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.

Diversifying across a wide range of stocks mitigates the impact of the worst performers on the fund’s overall performance. The portfolio holds more than 1,400 names, and its 10 largest stocks account for only 10% of its assets. It excludes companies listed in emerging markets, while a typical competitor has 7% of its assets allocated to companies from these regions. This difference modestly limits the fund’s opportunity set, but shouldn’t hurt its long-term, performance relative to the foreign large-blend Morningstar Category.

This fund’s biggest advantage is its ultralow expense ratio. Schwab charges just 0.06% annually for this fund, but this has not translated into superior category-relative performance. From its launch in November 2009 through November 2018, the fund’s total and risk adjusted returns landed near the midpoint of the category because the fund remains fully invested and foreign markets have not performed well by historical standards. Many of the fund’s better-performing competitors were more defensive, giving them an advantage during periods of lackluster market returns. Staying fully invested should improve the fund’s standing in the category during bull markets.

Fundamental View

Stocks from overseas can diversify a U.S.-centric portfolio. The fund's focus on developed-markets stocks means that it captures a majority of the available non-U.S. market capitalization. While it does not include stocks from emerging markets, the portfolio is still well-diversified across stocks, sectors, countries, and currencies.

The fund’s focus on large-cap stocks combined with 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. Corporations like these 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.

Market-cap-weighted funds like this one provide cost-efficient, diversified exposure to a majority of the opportunity set that active managers select from and make no active bets on specific regions, countries, sectors, or individual stocks. 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. Using this technique, a stock’s weighting floats with its price changes and requires little turnover to maintain its desired exposures. Low turnover translates into low transaction costs.

This portfolio effectively diversifies sector- and country-specific risks. Despite excluding firms listed in emerging markets, the fund's sector composition closely resembles the category average. Financials firms represent the largest sector weighting, at 20% of the portfolio. Stocks from eurozone countries account for 26% of the fund's assets, while Japan and the United Kingdom represent an additional 23% and 14%, respectively. This fund does not take measures to 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-U.S. Index, a well-diversified index that taps into 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 cap and targets firms that fall into the top 86% of each country by market cap. Buffers are applied around that threshold to mitigate unnecessary turnover. The final index contains more than 1,500 stocks. 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. The management team uses a statistical sampling approach to track this benchmark. This helps them save on transaction costs by avoiding stocks that are relatively more expensive to trade.

Fees

Schwab charges just 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 November 2018 managed to beat its target index by 10 basis points annually. This modest advantage stemmed from securities-lending revenue and the statistical sampling approach employed by the fund’s managers. Investors should not rely on these activities to consistently provide index-beating returns.

Alternatives

Silver-rated SPDR Portfolio Developed World ex-U.S. ETF SPDW (0.04% expense ratio) is slightly cheaper and 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.

Vanguard FTSE Developed Markets ETF VEA (0.07% expense ratio) has a portfolio similar to SPDW's. It tracks a cap-weighted index of developed-markets stocks, includes names listed in Canada and South Korea, and includes small caps. The fund’s expense ratio is competitive with SCHF and SPDW, underpinning its Silver rating.

Investors that 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 (0.10% expense ratio). Both funds cover thousands of stocks from more than 40 overseas markets, including emerging economies. VXUS and IXUS both earn Gold ratings.