Low-cost, diversified exposure to emerging-markets stocks.

fundcoverage@morningstar.comVWO
by Daniel Sotiroff
4/3/2019
Vanguard FTSE Emerging Markets ETF

Vanguard FTSE Emerging Markets ETF has a broad portfolio and rock-bottom expense ratio that should help it perform well over the long haul. It earns a Morningstar Analyst Rating of Bronze.

The fund tracks the FTSE Emerging Markets All Cap China A Inclusion Index, which includes large-, mid-, and small-cap stocks from 23 developing nations. Its market-cap-weighted approach benefits investors by capturing the market’s collective opinion of each stock’s value while mitigating turnover and trading costs. Markets usually get long-term prices correct, but they occasionally make mistakes. Investors can drive valuations up if they get excited about a particular area of the market, and market-cap-weighting will increase the fund’s exposure to it.

The portfolio’s broad reach helps mitigate the impact of the worst performing stocks. It holds more than 4,000 names while its 10 largest positions account for only 19% of its assets. It also provides greater exposure to a narrow segment of the emerging markets universe. Up until several years ago, locally traded Chinese stocks, or A-shares, were difficult for retail investors to hold due to restrictions imposed by the Chinese government. But these restrictions have loosened over time, and the fund had 4% of its assets parked in A-shares as of February 2019. This is about 3% more than many of its index-tracking peers.

Differences in country composition can cause the fund’s performance to deviate from its peers. Stocks listed in China make-up more than one-third of the portfolio, compared with 26% for the category average. It excludes Korean stocks because FTSE classifies Korea as a developed market while a typical competitor has a 12% stake.

Omitting Korean stocks has hurt the fund’s category relative performance as Korean stocks have been one of the better performing markets among emerging economies over the past several years. Consequently, the fund’s total and risk-adjusted returns landed near the category midpoint from its launch in June 2006 through February 2019. Its ultra-low 0.12% expense ratio should provide a long-term durable edge over its more expensive competitors.



Portfolio Construction

The portfolio’s construction process reasonably represents stocks from emerging markets, but it does not take measures to promote regional diversification and therefore earns a Neutral Process Pillar rating. The managers use full replication to track the FTSE Emerging Markets All-Cap China-A Inclusion Index. This benchmark’s construction starts with all stocks listed in 23 emerging markets. It sorts this broad cohort by their free float adjusted market capitalization and holds those that rank in the top 98% by market capitalization. It uses buffering rules around this cutoff point to help mitigate excessive turnover and applies additional liquidity screens to make the final index easier to track. The index rebalances semiannually in March and September. The final portfolio weights its holdings by market capitalization, which emphasizes large multi-national firms while keeping turnover and the related trading costs in check. But applying this technique to a broad collection of emerging market stocks heavily favors those listed in China, which compromises the fund’s geographic diversification. This fund may hold depositary receipts as well as locally listed stocks, so it can appear to have more holdings than the actual index.

Fees

This fund’s expense ratio is one of the cheapest in Morningstar’s diversified emerging markets category, so it earns a Positive Price Pillar rating. In November 2018, Vanguard closed the Investor share class and lowered the investment minimum on the Admiral share class to $3,000 from $10,000 ($3,000 was the minimum for the outgoing Investor share class). The Admiral shares cost 0.14% while the ETF’s fee is 0.12%. The ETF led the fund’s target index by 24 basis points annually over the trailing three years through February 2019. Vanguard’s fair value pricing strategy contributed to this mild advantage and investors should not expect this activity to produce long-term index-beating returns.

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