Wealth Manager

Why own foreign equities in one fund as opposed to carving up
the global markets by region, country, industry or the ever popular
developed/emerging distinction? The reasoning begins with the
notion of using a core foreign fund as a foundation on which to
layer additional strategy tilts á la the so-called core-satellite approach
to portfolio building.

It’s interesting to note that State Street and Vanguard’s new ETFs
also deliver exposure to the energy-heavy Canadian stock market.
Canada has been missing in action in MSCI EAFE and index funds
that track the benchmark, although investors can put it back into
the mix by purchasing iShares MSCI Canada Index Fund. Alternatively,
you could buy one of the new foreign ETFs.

To learn more about the new ETFs that favor a comprehensive
approach to foreign equities, we recently queried Dodd Kittsley,
director of ETF research at State Street Global Advisors, followed by an interview with Gus Sauter,Vanguard’s chief investment officer.

Dodd Kittsley,
State Street
Global Advisors

Q: A cynic might ask, why do investors need one
more equity ETF?

A: I think folks need to be cynical and take a lot
of the new ETFs with a grain of salt. There are so
many indices, and investors have many choices.
I think the right approach is to ask, “What does
each ETF have to offer and how is it unique?”

We see the MSCI ACWI ex-USA as a very compelling
index for an ETF because it offers one-stop
international exposure in a single product. It owns everything in
one ETF so you don’t have to worry about buying the parts in separate
trades and managing the drift between those parts. From an
asset allocation standpoint, for investors seeking assets outside
the U.S., this is an ideal vehicle for broad foreign-equity exposure.
It’s simply a good international core holding.

Q: How is ACWI ex-USA designed?

A: It seeks 85 percent market-cap exposure of each industry group
within each country outside the U.S. The index is rebalanced quarterly
and has extremely low turnover—on the order of 5 percent
annually. It’s a broad-based index, so you’re not seeing major
changes. The ETF managers will have the ability to make changes
intra-period as well, as all ETFs do. As with any 1940 Investment Act
mutual fund-structured ETF, changes can be made prior to or after
the index rebalancing, which can actually increase the efficiency
of index tracking. But the majority of ETF changes will occur when
the index rebalances.

Q: How does ACWI ex-USA differ from MSCI EAFE, which is perhaps
the best-known foreign equity index?

A: EAFE is a developed markets index, although EAFE omits Canada,
and ACWI ex-USA includes Canada. That’s another benefit of
ACWI ex-USA. When you think of the world of equities outside the
U.S., you have emerging markets and developed markets. Then
there’s Canada, which should be included among developed markets.
Canada represents about 6 percent of the market cap outside
the U.S. If you’re omitting Canada, you’re making a significant bet,
and I would say an unintended bet. ACWI ex-U.S. will help investors
avoid that bet.

One argument against using EAFE over the years has been its
relatively high allocation to Japan, which has been a drag on performance.
What’s the allocation for Japan in ACWI ex-USA?
Because ACWI ex-USA. includes emerging markets and Canada,
Japan’s weight is much lower relative to EAFE. Japan is currently
just under 19 percent in the ACWI ex-USA.

Q: Some 80 percent of ACWI ex-USA comes from EAFE stocks. Does
that make ACWI ex-USA essentially the same index as EAFE?

A: No, it’s quite different. Roughly 20 percent of ACWI ex-USA is
in Canada and the emerging markets. Canada is about 6 percent,
and emerging markets is 14 percent. That’s a meaningful amount
of the portfolio, especially when you look at something as volatile
as emerging markets. Certainly ACWI ex-USA’s performance will be
dominated by EAFE and its developed market countries. But adding
more volatile and potentially higher-return areas like emerging
markets is definitely meaningful.

Q: How many companies are in ACWI ex-USA?

A: A total of 2,131 companies in ACWI ex-USA as of November. If
you break that down, developed adds up to about 1,300 and just
over 800 for emerging markets.

Q: If you own ETFs tracking MSCI EAFE and MSCI Emerging Markets
indices, would that be the equivalent of owning ACWI ex-USA?

A: If you added Canada to the mix—and there is a Barclays ETF for
Canada—it would be extremely similar. An interesting thing to
look at would be the blended fee of owning the parts versus the fee
of owning everything in one fund.

Q: Why is the ACWI ex-USA an appropriate benchmark for foreign
equities?

A: It’s really the gold standard for all world benchmarks. A lot of
institutional investors are benchmarked to MSCI ACWI or MSCI
ACWI ex-USA. It’s the most recognized index in terms of an allworld
benchmark.

Q: Vanguard has announced it will be launching a similar ETF based
on the FTSE All World ex-USA index. Your reaction?

A: They’re going to be very similar [ETFs]. Investors and financial
advisors should look at which indices are the most recognized and
used by investors, especially for building asset allocation models.
ACWI ex-USA has been a benchmark of choice for broad investing
outside the U.S., especially for the institutional community. ACWI
ex-USA gives very broad exposure, but you’re going to find many
products that give similar exposure. More choices are better, although
you’ll find significant differences among the indices.

Q: MSCI publishes a gross and net version of ACWI ex-USA. Which
one is appropriate for your ETF?

A: Net is really what you’re going to be looking at in terms of assessing
tracking error. Net is the most appropriate because it’s accounting
for the withholding taxes before reinvesting the dividends.

Gus Sauter,
Vanguard

Q: Some readers may not be familiar with the FTSE
All World ex-USA Index. What is the overview?

A: It covers 48 countries in developed and emerging
markets. Notably, it includes Canada, which
frequently gets dropped out of many international
indices. So it will be very broadly diversified.

Q: Why should someone own foreign equity markets
in one fund as opposed to several?

A: When you cut up the international markets
into too many pieces, investors are taking a lot of risk—a lot of regional
risk, a lot of single-country risk. And those risks don’t usually
suit their long-term investment needs. Too frequently, people
buy the funds, regions or markets that have been hot. We think
that a broader exposure to the international markets is warranted,
rather than chasing more finely tuned segments.

At the same time, we do offer three regional index funds—Europe,
Pacific and emerging markets. All are MSCI indices. If you
combine the Europe and Pacific pieces, they equal the EAFE index.
We split EAFE into two pieces 15 years ago when we launched those
funds because at the time, Japan was 62 percent of EAFE and we
weren’t comfortable with a 62 percent weighting in one country.
We wanted to give investors the ability to underweight Japan. But
there’s no longer a dominant country in the broader [foreign equity]
market to the extent there used to be. We feel much more
comfortable with a cap-weighting approach to markets.

Q: What role should your new ETF have for strategic-minded investors?

A: The new ETF really should be the core holding. It’s very much
analogous to a total market U.S. equity index fund, which is the
building block with which you start. If you’re going to invest in a
total U.S. market index fund, then you can stress other segments
if you like. You can do the same with [a core international equity
fund]. You could invest in the total international market as your
core, and if you want to stress other markets or regions, you could
do that, but this would be the place to start.

Q: What are the benefits of your new international ETF?

A: It rebalances itself, and it’s extraordinarily tax efficient. Occasionally,
the various index providers will promote a country from
emerging markets status to the developed markets. If you own the
component pieces of the international marketplace, it’s going to
be tax inefficient because your emerging markets fund will have to
sell a country that will be picked up in one of your other funds. The
emerging markets funds will likely incur a capital gain. Owning it
all in one fund is extraordinarily tax efficient because [the stocks]
always stay in one fund.

Q: You have a mutual fund that’s similar to your new ETF. What’s the
difference?

A: One difference is structure. The Vanguard Total International
Stock is a fund of funds, whereas our new ETF will own the underlying
stocks. The other difference is allocation. The new ETF will
include Canada. Total International Stock is a combination of the
three regional funds [European, Pacific and Emerging Markets]
and doesn’t include Canada.

Q: What’s the significance of owning Canada?

A: Broader diversification. We don’t promote any country as being
an outperformer. We think that you get broader diversification by
including it.

Q: Why did you choose the FTSE All World ex-USA for the new ETF?

A: We like the broad diversification it provides. It uses the construction
rules we prefer—a float-adjusted, cap-weighted strategy. It did happen
to include Canada. We have two other FTSE indices that we track, so
we’ve got a relationship with FTSE. We’ve got a bigger relationship with
MSCI—we have 45 different funds that track MSCI indices. In fact,
our Total International Stock fund portfolio tracks MSCI indices.

Q: Speaking of MSCI, is FTSE All World ex-USA comparable to the
MSCI ACWI ex-USA, which State Street has chosen as the basis
for a new ETF that’s similar to your new fund?

A: Those two indices are going to perform very similarly. One will
outperform over one period, and another will outperform over
another, but I wouldn’t want to predict the two over a long period.
I think they’ll be quite similar in returns, at least on a gross basis.
It boils down to the fact that we already have an MSCI version of
this, and it seemed to make sense to offer something to people
who might want a FTSE index.

Q: The ETF trend of late is carving up markets into smaller slices, but
your new fund is going in the opposite direction. Any thoughts?

A: It says a lot about our philosophy. We want to create big, core offerings
for investors. We think slicing and dicing markets into ever finer
slices doesn’t serve investors well. Such products tend to be markettiming
vehicles and unfortunately, they tend to attract the most assets
after the performance has occurred, and so most investors lose money
in those funds. Our funds are designed to be long-term core holdings,
funds that we think will allow investors to maximize return.