Home Adviser Fund Update Vanguard Goes International Published October 1, 2010 Vanguard’s International Makeover Investors should put more of their money overseas! At least, that’s the message Vanguard was conveying this past week as they made significant changes to a number of funds. First up, a change in benchmarks and the addition of an ETFA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. share class for Total International Index. And on the heels of that news came a remodeling of a number of fund-of-funds to increase their international exposure. Total International’s New Look On September 24, Vanguard said it would switch Total International Index’s benchmark from the MSCI EAFE + Emerging Markets index to the MSCI All Country World ex-U.S. index, while also revealing plans to introduce a Total International ETF early in 2011. Taking a look under the hood of the new bogey, we found it offers greater diversificationA strategy for managing investment risk by investing in a mixture of different investments. Since different asset classes face different risks, even if one type of asset declines in value, others may not. than the EAFE + Emerging Markets index (approximately 6,000 holdings versus 1,714 at the end of August), and it adds Canada into the mix at about 8% of assets. In terms of performance, the AC World ex-U.S. index and Total International Index have had similar returns over the last decade or so (see chart below). For an idea of the comparative riskiness of the new benchmark, we ran a maximum cumulative loss (MCL) analysis for the most recent bear marketA period in which stock prices decline significantly from recent highs and remain below previous high marks for weeks or months. Generally, a decline of at least 20% in stock prices is considered the threshold marking the start of a bear market., which showed that the MSCI index lost 58.5%, while Total International Index lost 57.6%. It should be noted that the returns for the AC World ex-U.S. index (in the chart and MCL analysis) do not include any operating expenses, while those for Total International do. Investors in Total International will likely not notice any differences in the fund’s performance due to the switch. The second part of the story will have a wider-ranging impact. The introduction of Total International ETF will once again put Vanguard head to head with its competitors in the ETF marketplace, in this case, iShares and State Street, both of which have ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. tracking the same MSCI bogey. iShares’ ACWX has an expense ratio of 0.35% and State Street’s CWI charges 0.34%, while Vanguard’s Total International ETF is expected to cost just 0.20%. This is just the latest whack at the foundation of the ETF industry; a continuation of Vanguard’s efforts to undercut and overtake the competition. ETF investors stand to be the biggest beneficiaries. Vanguard Restructures Funds of Funds Following on the changes to its benchmark, Vanguard announced on September 27 it would be changing the composition of its Target Retirement and Managed Payout funds while also boosting international allocations in the LifeStrategy and Target Retirement funds as well as the original STAR. From inception, the Target Retirement and Managed Payout funds got their international exposure through holdings in a trio of funds, Emerging Markets Index, European Index and Pacific Index. Going forward, however, those three funds will be replaced by Total International Index, which obviously simplifies the funds’ structures, but also has the potential to reduce expenses—the current expense ratio on Total International (0.32%) should come down as assets in the fund increase, and should be smaller than the mixed operating expenses for the three foreign index funds formerly included in the funds’ portfolios. The move to increase international exposure in portfolios (whether through the firm’s official recommendations to clients or its allocation choices in funds and fund-of-funds) is one that has slowly developed over the years. Founder and former chairman Jack Bogle originally counseled that U.S. investors didn’t need any direct international investments at all, since the largest domestic companies provided enough overseas exposure on their own. As time went on, however, the firm began recommending that clients include an international component to their portfolios, started adding an international allocation in funds of funds (or boosting the existing allocation), while raising the percentage of foreign holdings permitted in the prospectuses of funds run by outside managers as well. In the table below, you can see the current and new target international allocations for the affected funds. In some cases, the percentage increases are quite dramatic–LifeStrategyConservative Growth, for instance, will see its international exposure more than double, while at Target Retirement 2005, the 6.9% to 11.0% change represents a 59% increase. Vanguard plans to maintain the overall balance between stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. in the Target Retirement and LifeStrategy funds, so this is strictly a readjustment to the equityThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid. portion of each portfolio, with the increase in foreign exposure coming at the expense of the domestic stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. allocation. The changes will increase riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. in the funds to a certain extent, but not enough so that investors should be overly concerned. Of course, our long-held opinion, voiced in this space regularly, is that investors can do better than relying on Vanguard’s one-size-fits-all lifecycle funds of funds. About Adviser Investments Adviser Investments operates as an independent, professional wealth management firm with expertise in Fidelity and Vanguard funds, actively managed mutual funds, ETFs, fixed-income investing, tactical strategies and financial planning. Our investment professionals focus on helping individual investors, trustsA legal document that functions as an instruction manual to how you want your money managed and spent in your later years as well as how your assets should be distributed after your death. 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