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A Smart Beta Approach to Developed Markets

This article was originally published on ETFTrends.com.

With stocks in ex-US developed markets trailing their U.S. counterparts this year, investors looking for overseas value may want to consider exchange traded funds with alternative weighting methodologies. That group includes the Schwab Fundamental International Large Company ETF (FNDF) .

FNDF's fundamental indexing methodology weights holdings by company sized based on adjusted sales, operating cash flow, and dividends plus buyback. The $4 billion fund celebrated its fifth birthday in August. FNDF targets the Russell RAFI-- Developed ex US Large Company Index.

“When the fund rebalances, it increases its exposure to stocks that have become cheaper relative to these metrics and cuts back on its exposure to those that have become more expensive,” said Morningstar. “This contrarian approach introduces a value tilt to the portfolio, and its price/book ratio is in line with the MSCI World ex USA Value Index. The fund's index calculates each stock's fundamental size annually, but the fund rebalances a different fourth of its portfolio each quarter. 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.”

Related: The Time is Right to Call on Quality Factor

Value stocks usually trade at lower prices relative to fundamental measures of value, like earnings and the book value of assets. On the other hand, growth-oriented stocks tend to run at higher valuations since investors expect the rapid growth in those company measures, but more are growing wary of high valuations.

More FNDF Details

FNDF holds nearly 880 stocks, over 85% of which are considered large- and mega-cap names. The top 10 holdings combine for 13.1% of the portfolio. Investors should expect performance difference between a smart beta option such as FNDF and cap-weighted international benchmarks.

“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.”

At the geographic level, FNDF is top heavy, allocating 47.70% of its weight to Japan and the U.K. Financial services and industrial stocks combine for a third of the fund's weight. FNDG garners a Bronze rating from Morningstar.

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