Why a total non-U.S. stock index fund may backfire
If you could buy only one mutual fund, it would make a lot of sense to buy a total market index fund. Since the fund aims to replicate the performance of a broad index, it may carry less risk than a more narrowly focused fund. And if you choose the right index to emulate, you should have decent returns.
But what if you were use three funds to achieve the same purpose? Would they perform better than the single fund?
We tested that question last month relative to the entire United States equity market, and the findings were clear: three Vanguard funds combined in equal weights and rebalanced annually outperformed a single Vanguard U.S. stock market fund that attempts to cover the universe of U.S large-cap, mid-cap and small-cap stocks.
Read more: Three against one: A battle of index funds
The 18-year annualized return for the trio of funds was more than 200 basis points higher than the single total stock market fund. Moreover, the trio of funds had better three-year rolling performance 75% of the time.
But that is one just one total stock market fund and just one asset class — U.S. stocks. What if you looked at another total market index fund, one that seeks to replicate non-U.S. stock markets?
BUYING FOREIGN STOCKS
Let’s see whether the three-against-one approach is superior when buying foreign stocks.
Vanguard has a one-stop offering for investors wishing to simplify their exposure to the non-U.S. equity market, namely the Vanguard Total International Stock Index fund (VGTSX). VGTSX has an 80% allocation to stocks from developed foreign economies, 15% to stocks from emerging markets, and the balance to cash and miscellaneous holdings.
Convenience and keeping costs low is obviously important, but raw performance is ultimately more important.
This type of fund is certainly convenient, but is it the best approach? Another approach would be to invest in separate funds from three international market segments: developed foreign large-cap value stocks, developed foreign mid-cap and small-cap stocks, and emerging market stocks. For the purposes of this comparison, the three individual foreign funds are Vanguard International Value (VTRIX), Vanguard International Explorer (VINEX) and Vanguard Emerging Markets Stock Index (VEIEX).
When combined, these three funds seek to accomplish what the Vanguard Total International Stock Index is attempting to achieve. The time frame for this comparison study is the 18-year period from Jan. 1, 1999, to Dec. 31, 2016. Performance data were extracted from the Steel Systems Mutual Fund database.
The annual returns of these four international funds are shown in the chart “Four Stalwarts.” Over the past 18 years, Vanguard International Explorer and Vanguard Emerging Markets Stock Index have individually significantly outperformed Vanguard Total International Stock Index, by 562 bps and 438 bps respectively. Vanguard International Value also outperformed VGTSX, but by a more modest 79 basis points.
COMES AT A COST
Outperformance does come at a cost, however. The standard deviation of returns for VINEX and VEIEX were each roughly 43% higher than VGTSX. In studying the annual returns carefully, it’s clear that much of that larger standard deviation came from large positive returns rather than unusually large negative returns. The exceptions are the relatively large losses experienced by VEIEX in 2000, 2008, and 2015.
Also worth noting is the lower expense ratio of Vanguard Total International Stock Index — less than half any of the other three funds. That is certainly attractive. But it is important to remember that stated performance of any fund already accounts for its expense ratio. Thus, the slightly lower expense ratio of VGTSX pales in comparison to the performance advantage of the individual international stock funds. Convenience and keeping costs low is obviously important, but raw performance is ultimately more important.
Let’s now examine what happens when we blend the results of these three individual funds and stack them up against Vanguard Total International Stock Index.
We have two options. The first is to invest in the three narrower funds in the same allocations that VGTSX uses (which is 80% to developed foreign markets and 20% to emerging markets). To do this, VTRIX will have a 40% allocation, VINEX a 40% allocation, and VEIEX a 20% allocation. Each fund is then rebalanced annually to keep the allocations in line.
The most important approach is building a portfolio that optimizes the exposure to the asset classes you are seeking to cover, and then keep the cost as low as possible.
The second option is to simply invest equally in each fund, namely three allocations of 33.33%. The results are shown in the chart “Extensive Coverage.” Clearly, the three-fund approaches have produced better performance that Vanguard Total International Stock Index over the past 18 years (with a slight edge to the equally weighted trio).
Gaining exposure to foreign equities is best accomplished by using individual funds rather than a total-index approach. And this is not simply an artifact of looking at this particular 18-year time frame. It turns out that the three-fund approach with 80% weighting to developed markets and 20% weighting to emerging markets outperformed VGTSX in 94% of the rolling three-year periods from 1999 to 2016. The equally weighted three fund approach had better three-year rolling returns than VGTSX 88% of the time.
Is it more expensive to use a three-fund approach? Yes, slightly. VGTSX has an expense ratio of 18 basis points compared with 39 bps for the equally weighed trio.
However, the payoff over the past 18 years was considerable. The equally weighted portfolio of three funds grew from $10,000 into $39,685, whereas VGTSX had an ending account value of $20,147.
These ending account values take into account expense ratios. Focusing too much on expense ratio can produce a blind spot.
The more important consideration is building a portfolio that can optimize the exposure to the asset classes you are seeking to cover — and then keep the cost as low as possible. In this case, as we saw in last month’s article, it is far better to divide and conquer.