Vanguard Uses Dual Shares To Divvy Up Foreign Small-Caps

• By Murray Coleman
• On 1:12 am EST, Tuesday December 23, 2008

Is the Vanguard international small-cap index stock fund a disappointment before it ever gets off the ground?

Some investors aren't happy after the Valley Forge, Pa.-based giant filed to launch the FTSE All-World ex-US Small-Cap Index Fund. The passively run mutual fund is slated to come out with an expense ratio of 0.60%. (See related story here.)

That's more than its own International Explorer Fund (VINEX), which isn't even passively managed, and which recently reopened to new investors with a price tag of 0.35% a year. (See related story here.)

But look beyond the top-line numbers. When you consider the subtle differences Vanguard is attacking in each market, the pricing lives up to the firm's low-cost image. The new fund should fill out the competitive landscape in both mutual funds as well as exchanged-traded funds among diversified international small-cap portfolios.

In fact, this might be the most well-leveraged pairing we've seen yet by Vanguard in taking advantage of its dual-share-class strategy to attack two markets at once.

Analyzing Each Fund By Market

Let's start with the basics. When considering the new Vanguard fund, it's important to divide it into distinct product lines. One will function in the marketplace—as well as investors' portfolios—as a traditional mutual fund. The other will become an ETF by virtue of its second-share-class structure.

While both will passively follow the same benchmark, Vanguard is planning on setting vastly different cost structures for each market.

The ETF version will be 0.22% less expensive. That puts it slightly below the lowest-priced ETF in the category, the iShares MSCI EAFE Small Cap (NYSEArca:SCZ - News), which charges 0.40%. As a result, the proposed Vanguard small-cap international index fund will indeed lower the bar for ETF investors.

But it won't necessarily do the same for index mutual funds. For example, if you've got access to Dimensional Fund Advisors—a planner who charges fees on top of the underlying fund fees—then you can choose the DFA International Small Company Fund (DFISX) at 0.55%. There's also an even pricier fund, the DFA International Small Cap Value (DISVX). Also out of DFA are funds for small-cap European stocks and a core all-cap-type international portfolio with around 10% in small-caps at 0.41%.

Of the 228 no-load mutual funds categorized as focusing on foreign small- and mid-cap stocks in Morningstar's database, only one's classified as index-based. That's the Schwab Fundamental International Small-Mid Company Index Fund (SFIVX). It came out earlier this year and has an expense ratio of 0.79%. The fund tracks the FTSE RAFI Developed ex-US Mid-Small 1500 Index, meaning it's using a fundamental indexing methodology created by Rob Arnott's Research Affiliates.

Here's where you might want to start taking notes. The same benchmark is licensed to an ETF. That's the PowerShares FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (NYSEArca:PDN - News). It comes with an expense ratio of 0.75%.

More Choices As Market Expands

But there's more. The first diversified foreign small-cap ETF based on an index using business fundamental weightings rather than traditional market-cap sizing is the WisdomTree International SmallCap Dividend Fund (NYSEArca:DLS - News). It comes with an expense ratio of 0.58% and sticks to developed markets as well.

Getting dizzy? Wait, there's more.

The new Vanguard foreign small-cap mutual fund and ETF will track an FTSE index that resembles the benchmark used by the iShares FTSE Small-Cap ex-North America ETF (NasdaqGM:IFSM - News). The difference is that Vanguard has decided to pick the purely market-cap-sized weighted FTSE index combining both developed as well as emerging markets.

So besides pricing itself considerably under its competition either way you look at it—mutual funds or ETFs—Vanguard is also throwing in developing markets exposure you won't get in the other indexes. It's a strategy the fund provider has implemented with success in its Total International Stock Market Index Fund (VGTSX) to separate itself from other developed-market-centric competitors such as Fidelity's lower-priced Spartan International Index Fund (FSIIX).

Now, Vanguard is ready to bring the same approach to the small-cap international stock field. Sometime early next year, we'll see a full selection of entries that will give virtually anyone a choice between traditional market-cap sizing and fundamental indexing in either mutual fund or ETF forms.

That's a real advancement considering just about two and a half years ago, investors had nothing to choose from in the indexing universe. Now, you need a scorecard just to keep up. So here you go:

Nontraditional Diversified Small-Cap International Funds

Name	Symbol	Developed	Emerging	Top Sectors	Top Countries	Exp.	Structure
WidsomTree Int'l SmallCap Dividend	DLS	94%	6%	Capital Goods, Materials	Japan, U.K., Australia	0.58	ETF
PowerShares FTSE RAFI Developed Markets ex-U.S.	PDN	96.6%	3.4%			0.75	ETF
Schwab Fundamental International Small-Mid	SFIVX	96.6%	3.4%	Materials, Financial Services	Japan, U.K., Australia	0.79	Mutual Fund

Market-Cap-Sized Small-Cap International Funds

Name	Symbol	Developed*	Emerging*	Top Sectors	Top Countries	Exp.	Structure
Vanguard FTSE SC	Still In Registration	87.43%	12.57%	Financials, Con. Svcs.	Japan, U.K.,	0.60/0.38	Mutual Fund/ETF
iShares FTSE Dev. Mrkts.	IFSM	97.55%	2.45%	Industrials, Financials	Japan, U.K.	0.50	ETF
iShares  EAFE Small Cap Index	SCZ	98.02%	1.98%	Industrials, Financials, Cons. Disc.	Japan, U.K., Australia	0.40	ETF
SPDR Int'l SC	GWX	94.47	5.53	Industrials, Financials, Cons. Disc.	Japan, U.K., Canada	0.60	ETF
Vanguard Int'l Exp.	VINEX	92.90	7.10	Bus. Svcs., Industrials, Cons. Svcs.	Japan, U.K., Switzerland	0.35%	Active Mutual Fund

Sources:Companies, Morningstar          *Unofficial estimates based on MSCI category breakdowns, company data

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Murray Coleman is managing editor at Indexuniverse.com. He welcomes comments and suggestions for future columns at:mcoleman@indexuniverse.com.  

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