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Investigate This International ETF

ETF Professor

One of this year's most obvious equity market themes is the sad state of ex-U.S. developed markets stocks compared to domestic equivalents. The widely followed MSCI EAFE Index finished the third quarter with a year-to-date loss of 3.3 percent, but the S&P 500 is up about 9 percent this year.

Suffice to say, international stocks are out of favor, but that could also mean now is the ideal time to consider this asset class and the relevant exchange traded funds.

What Happened

Investors mulling developed markets exposure may want to consider strategies beyond cap weighting, including the fundamentally-weighted Schwab Fundamental International Large Company Index ETF (NYSE: FNDF). The $4 billion FNDF follows the Russell RAFI-„- Developed ex-U.S. Large Company Index, a benchmark that eschews weighting by market capitalization.

Factors included in that index's methodology are buybacks, cash flows and dividends, giving FNDG a value tilt.

“The fund's index calculates each stock's fundamental size annually, but the fund rebalances a different fourth of its portfolio each quarter,” said Morningstar in a recent note. “Breaking up the rebalancing should be an improvement over a single annual rebalance because it helps reduce the risk of poorly timed rebalances and reduces the market-impact cost of trading.”

Why It's Important

Investors often wonder about the ability of fundamentally-weighted funds to outperform cap-weighted rivals over various holdings periods. FNDF is an example of a smart beta international fund that does offer the potential for outperformance. Year-to-date, the Schwab fund is performing less poorly than the MSCI EAFE Index and over the past three years, FNDF is ahead of the MSCI benchmark by 610 basis points.

“This alternative approach can drive differences between the fund and the MSCI World ex USA Value Index,” said Morningstar. “The benchmark has almost 35% of its assets in financial stocks while the fund is closer to 19%, meaning it does a better job of spreading its bets across different industries. Over the past several years, it has also tilted toward materials and energy firms following declines in commodity prices. These firms can be risky because they may not always compensate investors for the additional volatility from their commodity exposure.”

FNDF holds 876 stocks, nearly a third of which hail from the financial services and industrial sectors. Consumer discretionary and energy names combine for almost a quarter of the fund's weight.

What's Next

“Despite its value orientation, the fund also includes growth stocks. This should improve its reach and allow the fund to take advantage of mean reversion in valuations wherever they occur in the large-cap market segment,” said Morningstar.

The research firm has a Bronze rating on FNDF.

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