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  • Home>Research & Insights>Investment Insights>Cheap Exposure to Foreign Stocks in Developed Markets

    Cheap Exposure to Foreign Stocks in Developed Markets

    Vanguard FTSE Developed Markets ETF combines heavy diversification with an ultralow fee.

    Daniel Sotiroff, 10/25/2017

    Vanguard FTSE Developed Markets ETF VEA is a compelling choice for broad exposure to foreign developed markets. Its market-cap-weighted portfolio promotes low turnover, effectively diversifies company-specific risk, and accurately represents its target market. These characteristics, combined with a rock-bottom expense ratio, support a Morningstar Analyst Rating of Silver.

    The exchange-traded fund owns more than 3,600 stocks across foreign developed markets and weights them by market capitalization. This approach promotes low turnover and skews the portfolio toward large multinational firms with global operations, such as Nestle, Toyota, and Novartis. Since the fund's inception in 2007, its turnover ratio has averaged 8%, which helps keep transaction costs low. In contrast, the foreign large-blend Morningstar Category's average turnover was greater than 50% in the most recent year.

    This fund's country exposure exhibits some notable differences compared with category peers. Stocks listed in Canada and South Korea account for less than 5% of the average portfolio in the category. In contrast, these two countries account for more than 10% of this fund's assets, and names such as Samsung Electronics and Royal Bank of Canada are among the fund's top 20 holdings. Additionally, Japanese stocks currently account for almost 22% of this fund's assets, slightly more than the 18% category average.

    A well-diversified portfolio and sizable cost advantage should give this fund an edge over the long term. This advantage helped the fund outperform the category average by 31 basis points annualized from its inception in July 2007 through September 2017. The fund's performance was particularly strong from May 2012 through May 2014, outpacing the category average by 2.40%, partially because of more-favorable stock exposure in the financial-services sector.

    Fundamental View
    Foreign stocks can diversify portfolios that have heavy exposure to U.S. equities. However, this diversification benefit tends to be lower among foreign developed-markets stocks compared with emerging-markets stocks. During the trailing 10-year period through September 2017, the correlation between the S&P 500 and the MSCI World ex USA Index, which also tracks foreign developed markets, was 0.90. During the same period, the correlation between the S&P 500 and the MSCI Emerging Markets Index was 0.80. Although the diversification benefit may not be as great for foreign developed-markets stocks, they have historically exhibited lower volatility than emerging-markets stocks.

    This broad market-cap-weighted portfolio reflects the composition of the market and promotes low turnover. And it effectively diversifies company-specific risk. The fund's top 10 holdings account for less than 9% of the portfolio, compared with the category average of more than 25%. Yet its weighting approach could tilt the portfolio toward firms as they become larger and more expensive and away from firms as they become smaller and cheaper, which may have higher expected returns. Market-cap weighting also pulls the portfolio toward large multinationals, so the countries where its holdings are listed are not necessarily indicative of the economic exposure they provide. These companies tend to be more profitable and less volatile than their smaller counterparts.

    Most of the fund's sector weightings are similar to the category average. However, it has slightly less exposure to technology companies than the category average. Financial-services companies account for the fund's largest sector allocation at 21% of the portfolio. Large banks such as HSBC Holdings and Commonwealth Bank of Australia are among the fund's top 20 holdings. 

    Similar to category peers, Japan and the United Kingdom represent the fund's two largest single-country exposures, accounting for nearly 40% of the portfolio. These countries are both dealing with economic headwinds. The U.K.'s recent decision to leave the European Union, along with Japan's aging workforce and tremendous public debt, have the potential to slow new investment and weaken demand. However, these risks should already be reflected in market prices. Additionally, a large proportion of holdings within these two countries are multinationals (like Toyota and BP) with global operations that diversify economic risk.

    Daniel Sotiroff is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.