Due to my inclusion of single country ETFs in various portfolios, I typically hold over a dozen international equity ETFs at any given time.
Most investors prefer simpler international holdings than that, and there are broader ETFs that can answer the call. Investors, however, should pay attention to the geographies and sectors involved in any multi-country ETF to ensure that the filtering method that the ETF uses makes sense for long-term total return potential.
The Drag of Market Cap Weighting
I am not a big fan of pure market cap weighted international ETFs such as the Vanguard Total International or All-World ETFs (VXUS and VEU), or anything that follows the MSCI EAFE index (like iShares EFA). These ETFs concentrate very heavily into nations with the largest current market capitalization, such as Japan and the UK, which means they emphasize countries with past growth rather than emphasizing countries with the greatest forward return potential.
Additionally, fund inflows into multi-country cap-weighted indices constantly flow away from troubled areas and into places where everything is great, because they buy more heavily into higher market cap countries. Value investors often want to do the opposite- they want to buy into places that have blood in the streets and where everything is discounted.
In my (no paywall) article, This Strategy Tripled the S&P 500 Over 25 Years, I reviewed research from Meb Faber and Norbert Keimling which showed that, historically, investors make a lot more money by buying into the cheapest regions of the world (places with trouble, in recessions, and out of favor) than by buying into regions that are expensive and have outperformed recently.
This chart from Star Capital is a great example that shows how there is almost a perfect inverse relationship between what outperformed during the previous decade 1999-2009 and what outperformed during the next decade 2009-2019:
Cap-weighting an index within a single country (like the S&P 500, for instance) is generally not the best weighting method, but it’s not bad either. However, cap-weighting a multi-country index really misses a lot of opportunities and constantly overweights expensive regions that have recently outperformed.
My Favorite International ETF: VIGI
There is a popular Vanguard ETF called the Dividend Appreciation ETF (ticker: VIG) that tracks American companies with at least 10 years of consecutive annual dividend growth. It is frankly not that interesting because it has almost perfectly matched the S&P 500 since its inception 13 years ago.
However, Vanguard’s newer International Dividend Appreciation ETF (ticker: VIGI) is one I like a lot going forward as part of a diversified portfolio. It invests in international companies that have at least 7 years of consecutive annual dividend growth.
Like most index funds it is far from perfect, but if I had to tell a relative to buy just one international ETF for their portfolio for the long run, it would be this one.
There are a lot of companies I don’t like in the world. The floundering European banking sector, for example, is not particularly something I want a lot of exposure to. Europe in general is not very attractive at the moment despite being cheaper than the U.S. market, and the same holds true for Japan.
However, I do like growth stocks from those regions, and elsewhere. Especially growth at a reasonable price (GARP). In a world with demographic issues and slow growth, filtering for ones that have raised dividends for 7 consecutive years is a good start. That’s why I like many of the holdings of VIGI.
Here is the breakdown of VIGI’s regional exposure and top ten companies:
However, where this ETF really shines is when it is compared to its American equivalent, VIG at the moment. Would you prefer to buy companies with fast growth cheaply, or slow growth expensively? Because that’s basically the VIGI vs VIG comparison currently:
Over the past five years, companies within VIGI have grown earnings at a 10.6% annual rate compared to companies in VIG that only grew at 6.4%. Despite this slower growth for VIG, it has an average P/E ratio about 20% higher and an average P/B ratio about 50% higher than VIGI. These higher valuations have driven VIG’s outperformance over VIGI since VIGI’s inception in early 2016:
VIGI has a lot more technology exposure than VIG. Technology makes up 18% of VIGI’s portfolio, which makes it the fund’s second largest sector. Its largest sector is consumer staples, which is defensive in a slow growth environment that may be entering a recession. On the other hand, technology makes up only 9% of VIG’s portfolio as its sixth largest sector, and its biggest area of exposure is industrials, which are highly exposed to slowing economic growth.
So, VIG has half as much technology exposure, slower 5-year trailing earnings growth, and more cyclical risk exposure, but is at least 20% more expensive compared to VIGI.
In terms of the equity risk premium, VIGI is even less expensive than VIG. The most common reason cited for abnormally high current U.S. equity valuations (CAPE ratio of 30) is that U.S. interest rates are so low, which pushes up the valuations of most assets including stocks.
In the rest of the developed world, though, their interest rates are even lower and yet their equity valuations are far lower as well (15-20 CAPE, generally). This is partially explained by different sector exposure (like far less technology exposure in Europe than in the United States), but even when factoring out sector differences, foreign stocks are still somewhat cheaper. The VIGI vs VIG comparison makes it even more clear- VIGI has a slightly more favorable sector allocation (more technology) and faster growth but trades more cheaply.
Look Forward, Not Backward
Equities in the United States have been the hot outperformers over the past decade. U.S. stock valuations are among the highest in the world, which is partially deserved due to broad diversification and technology exposure, but also partially just based on the fact that everyone wants to own U.S. equities and fewer people want to hold European equities, Japanese equities, or emerging markets.
This is nothing new; investors always want to invest in what has done well recently, and places all around the world have their problems. Most of those problems are priced in, and usually more than priced in.
Between VIG and VIGI, I like VIGI more over the next 5+ years. More specifically, I like it as part of a diversified portfolio. It offers exposure to 400 companies from 30 developed and emerging markets.