ETF launches have become routine in the 21st century, especially when it comes to targeting ever narrower slices of the capital markets. But two new ETFs are bucking the trend on the foreign-equities front.
State Street Global Advisors launched an ETF in January that delivers the world's foreign equities in one portfolio tracking a broad, capitalization-weighted index. Vanguard is set to roll out a competing ETF, and may have already done so by the time you read this. Although there are mutual funds holding foreign developed- and emerging-market equities in one portfolio, putting all non-U.S. stocks in one product is an idea that has eluded ETFs. No longer, thanks to State Street's newly minted SPDR MSCI All Country World Index ex-USA (Amex: CWI) and the pending Vanguard FTSE All-World ex-USA.
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 ? 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 and Gus Sauter, Vanguard's chief investment officer.
Dodd Kittsley - State Street Global Advisors
A cynic might ask, why do investors need one more equity ETF?
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.
How is ACWI ex-USA designed?
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.
How does ACWI ex-USA differ from MSCI EAFE, which is perhaps the best-known foreign equity index?
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.
Some 80 percent of ACWI ex-USA comes from EAFE stocks. Does that make ACWI ex-USA essentially the same index as EAFE?
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.
How many companies are in ACWI ex-USA?
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.
If you own ETFs tracking MSCI EAFE and MSCI Emerging Markets indices, would that be the equivalent of owning ACWI ex-USA?
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.
Why is the ACWI ex-USA an appropriate benchmark for foreign equities?
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 all-world benchmark.
Vanguard has announced it will be launching a similar ETF based on the FTSE All World ex-USA index. Your reaction?
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.
MSCI publishes a gross and net version of ACWI ex-USA. Which one is appropriate for your ETF?
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
Some readers may not be familiar with the FTSE All World ex-USA Index. What is the overview?
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.
Why should someone own foreign equity markets in one fund as opposed to several?
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.
What role should your new ETF have for strategic-minded investors?
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.
What are the benefits of your new international ETF?
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.
You have a mutual fund that's similar to your new ETF. What's the difference?
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.
What's the significance of owning Canada?
Broader diversification. We don't promote any country as being an outperformer. We think that you get broader diversification by including it.
Why did you choose the FTSE All World ex-USA for the new ETF?
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.
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?
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.
The ETF trend of late is carving up markets into smaller slices, but your new fund is going in the opposite direction. Any thoughts?
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 market-timing 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.
James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.
