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ETF Specialist

An Attractive European Stock ETF

This is one of the cheapest and most comprehensive Europe-stock funds available.

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 Vanguard FTSE Europe ETF (VGK) is a strong choice for broad exposure to European stocks. It is tied with iShares Core MSCI Europe (IEUR) as the cheapest fund in the Europe-stock Morningstar Category and offers one of the most comprehensive portfolios available. The fund targets stocks listed in developed European countries representing the largest 98% of the investable market and weights them by market capitalization. This approach effectively diversifies risk and promotes low turnover. Prior to October 2015, the fund excluded most small-cap stocks but has since added them to improve diversification.

Developed European market stocks account for about a fifth of the world's investable market capitalization. Therefore, they should carry a meaningful weighting in a globally diversified portfolio. Investors who own broadly diversified international-stock funds may already have significant exposure to European stocks. But this could serve as a core holding for those looking to increase their exposure to this region. Most of the fund’s largest holdings are multinational firms with global operations such as  Anheuser-Busch Inbev (BUD),  Bayer (BAYRY),  Royal Dutch Shell (RDS.A), and  Nestle (NSRGY). Therefore, it does not offer clean exposure to the European economy.

Many of the fund’s sector and country weightings are similar to the U.S. open-end Europe-stock category average. However, it has greater exposure to financial services stocks and a little less exposure to the technology sector. Stocks listed in the United Kingdom and Switzerland account for 44% of the portfolio. Most of the remaining assets are invested in stocks listed in the eurozone, giving the fund significant exposure to fluctuations in the value of the euro. Like most of its peers, the fund does not hedge its currency risk. Currency fluctuations tend to make the fund more volatile than broad U.S. stock indexes.

The fund hasn't stood out on performance during the trailing 10-year period through August 2016. During that time, it lagged the average return of its surviving mutual fund peers by 64 basis points annualized, with comparable volatility. Including nonsurviving funds, that underperformance fell to 10 basis points. Despite its middling performance, low fees should give the fund an edge over the long term.

Fundamental View
Britain’s decision to leave the European Union has created uncertainty about the future of its relationship and commercial trade with the bloc. This potential fallout from the exit could slow new investment and weaken demand, potentially hurting the fund’s holdings. 

Elevated macroeconomic risk is not new to investors in European stocks. In the aftermath of the global financial crisis, the region was reeling from a sovereign debt crisis and weak demand stemming from austerity measures to bring debt under control. These events are difficult to predict, and once they occur it is often too late to take corrective action. But uncertainty does not necessarily mean that it is prudent to avoid European stocks. They should be priced to offer competitive compensation for their risk.

The European Central Bank has pursued aggressive monetary policy to keep interest rates ultralow and stimulate demand. Low interest rates can spur demand by making it cheaper to borrow to finance consumption and investment. They also help prop up asset prices. While interest rates must almost certainly rise in the future, they will likely remain low in the near term.

About 45% of the fund’s assets are invested in stocks listed in the eurozone. It also has significant exposure to British stocks, which account for nearly 31% of the portfolio. But the countries where the fund’s holdings are listed are not necessarily indicative of the portfolio’s economic exposure. While most of these firms do a lot of business in Europe, the largest holdings tend to have global operations, just like most large U.S. stocks.

Market-cap weighting skews the portfolio toward the largest stocks in Europe, such as  Novartis (NVS),  HSBC Holdings (HSBC),  Roche Holding (RHHBY), and  Vodafone Group (VOD). But the average market cap of the fund’s holdings is similar to the category norm. There are no limits on sector or country weightings, but the fund’s broad reach helps diversify risk. It includes more than 1,000 stocks, and the top 10 holdings only represent 16% of its assets.

Many of the fund’s holdings do not enjoy durable competitive advantages. Of the holdings Morningstar equity analysts cover, 30% by market value carried a Morningstar Economic Moat Rating of None at the end of July 2016, which was comparable to the category average. Competition will likely limit these firms’ profitability.

Although considerable risks remain, the fund’s holdings are trading at lower valuations than their U.S. counterparts. At the end of August, the constituents in the fund’s benchmark were trading at a lower average price/forward earnings multiple (16.6) than those in the Russell 3000 Index (19.5), like most of its category peers. And they offered a higher average estimated dividend yield.

Portfolio Construction
In October 2015, Vanguard transitioned the fund from the FTSE Developed Europe Index to the FTSE Developed Europe All Cap Index, which extended the fund’s reach to include small-cap stocks. This index includes large-, mid-, and small-cap stocks listed in developed European countries, including Switzerland and the U.K.

FTSE ranks all stocks in the region by free-float-adjusted market cap and excludes those representing the smallest 2% of the market to define the investable universe. The all-cap index targets stocks representing the largest 98% of the remaining universe by market cap. However, FTSE allows existing constituents that drop slightly below that threshold to stay in the index to reduce turnover. Qualifying stocks must also meet minimum liquidity requirements. The index weights its holdings by float-adjusted market cap and reconstitutes semiannually in March and September. This weighting approach keeps turnover low and tilts the portfolio toward the largest stocks. The fund applies near full index replication, which should keep tracking error low.

Fees
This is one of the cheapest funds in its category. It charges a razor-thin 0.12% expense ratio. It also offers good liquidity, which should make it cheap to trade. Vanguard engages in securities lending, the practice of lending out the fund's underlying holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses.

Alternatives
Investors attracted to VGK's broad coverage of the European market might also consider iShares Core MSCI Europe (IEUR), which charges the same 0.12% expense ratio. It offers market-cap-weighted exposure to large-, mid-, and small-cap stocks in most of the countries VGK covers. More than 95% of the assets in their portfolios overlap. But VGK has a larger asset base and more fully replicates its index than IEUR.

Investors looking for pure exposure to stocks listed in the eurozone might consider  iShares MSCI Eurozone (EZU) (0.48% expense ratio). EZU's exclusion of British and Swiss stocks has made it slightly more volatile than VGK during the past five years. SPDR EURO STOXX 50 ETF 50 (FEZ) (0.29% expense ratio) is a cheaper, but more concentrated, eurozone option. FEZ invests in a narrower portfolio of 50 blue-chip companies.

A currency-hedged fund, such as  iShares Currency Hedged MSCI Eurozone (HEZU) (0.50% expense ratio) or  WisdomTree Europe Hedged Equity ETF (HEDJ) (0.58% expense ratio), might also be worth considering. HEZU holds EZU and uses forward contracts to hedge the currency risk. HEDJ targets dividend-paying eurozone listed stocks that generate at least half of their revenues outside of Europe. It weights its holdings by the value of dividends each stock pays and hedges its currency exposure with forward contracts.

A small-cap European fund, such as WisdomTree Europe SmallCap Dividend ETF (DFE) (0.58% expense ratio), may offer cleaner exposure to the European economy. This fund invests in dividend-paying small-cap European stocks and weights its holdings by dividends, similar to HEDJ.

 

 

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Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.