One of the investors I like to listen to is Howard Marks of Oaktree Capital Management. Marks has written that “in the world of investing … nothing is as dependable as cycles.” This doesn’t mean markets follow a set schedule, and no one rings a bell at the beginning or end of an investment cycle. But all cycles eventually end and are replaced by a new trend.
At times, investors seem to forget this — assuming the current trend will continue forever. But when the cycle does end and a new trend begins, opportunity is created for patient, long-term investors.
The current cycle has been one of U.S. stocks leading foreign stocks — both those in developed and emerging markets. As a result, we are nearing a “lost decade” in foreign stocks, and that includes Vanguard international funds. Since peaking at the end of October 2007 through end of June 2017, Vanguard Total International Stock Index (MUTF:VGTSX) has gained just 1.1% and Vanguard Emerging Markets Stock Index (MUTF:VEIEX) has declined 10.3% — yes, that includes dividends. Over the same time, Vanguard Total World Stock Market Index (MUTF:VTSMX) has returned 94.9%.
Is the current cycle coming to an end? The honest answer is that I don’t really know — cycles can last longer and go higher than many would expect.
I do know that foreign stocks and particularly emerging market stocks have been out of favor with investors. The argument that U.S. companies earn so much revenue overseas that investors don’t need to own foreign stocks has once again become popular — a sign that the cycle of U.S. stock dominance may be getting a bit extended.
With the refrain “markets are cyclical” in mind, here are three intriguing Vanguard international funds to buy for the second half of the year.
Vanguard International Growth (VWIGX)
Expenses: 0.46%, or $46 annually on every $10,000 invested
First up is my favorite foreign fund, Vanguard International Growth (VWIGX). International Growth’s year-to-date performance showcases its managers’ formidable skills. With a 24.2% gain for the year through June 30, International Growth is the single best-performing fund in the Vanguard universe — foreign or domestic.
And there may be more to come.
The European Central Bank looks to be ending (or is suggesting they are going to end) their bond-buying stimulus program. This helped push the euro higher, which is a tailwind for International Growth, as dollar weakness translates into better returns for U.S. investors with holdings denominated in non-dollar currencies.
VWIGX, co-managed by Baillie Gifford & Co. and Schroder Investment Management, has been one of the few multi-managed funds that actually works. That’s thanks to a reasonably compact portfolio (120 or so stocks) — including Tencent Holdings Ltd. (OTCMKTS:TCEHY) and Alibaba Group Holding Ltd (NYSE:BABA) at the top — and index-beating returns over long periods of time.
For an example of those index-beating returns, take a look at the chart above, which shows International Growth handily beating Total International Stock Index since February 2009.
But I like rolling returns even better than point-in-time returns because they give us lots of data points over which fund performance can be measured. Rolling returns, calculated month-to-month, show returns from January through December, February through January, etc. Rolling returns for VWIGX and VGTSX on one-, three and five-year bases tell a more complete story than a point-in-time return can.
The numbers speak for themselves, but compare the average rolling return for both funds. You’ll find that International Growth has been a consistent outperformer, beating the broad international index fund by an average 2.1%, 1.6% and 1.2% per annum over rolling one-, three- and five-year periods.
This good fund got a whole lot better in July 2016, when Vanguard trimmed International Growth’s manager ranks from three to two by firing M&G Investment Management. Baillie Gifford now manages 60% of the assets, and Schroder runs about 40%.
A change for the better, as is evidenced by VWIGX’s performance so far in 2017.
Vanguard Emerging Markets Stock Index (VEIEX)
Now’s a reasonable time for growth-oriented investors to take a little away from the U.S. and add a measured and dedicated allocation to emerging markets.
And Emerging Markets Stock Index, managed by Michael Perre and Jeffrey D. Miller, is my choice for this space.
The relative performance chart to the right provides a clear visual of both the current cycle as well as prior cycles. When the line in the chart is rising, Emerging Markets Stock Index is outperforming Total Stock Market Index. In the mid-to-late 1990s, U.S. stocks left emerging-market stocks for dead as the U.S. rode the tech bubble up and EM markets grappled with currency crises. Then the cycle turned, and emerging-market stocks took the lead in the 2000s.
The past seven years have seen U.S. stocks outperform EM stocks by a wide margin.
This underperformance has resulted in cheaper valuations in the emerging markets relative to U.S. markets. Consider that Total Stock Market Index had a 21.2 price-to-earnings ratio at the end of June, which means investors were paying $21.20 for each dollar of earnings generated by the companies in the index. Meanwhile, Emerging Markets Stock Index only traded with a P/E ratio of 14.5 — this in markets where economic growth tends to be faster than here at home. And this P/E has decreased since March of this year, despite the growing momentum of emerging stocks.
Recently, VEIEX — which holds Tencent, Taiwan Semiconductor Mfg. Co. Ltd. (ADR) (NYSE:TSM) and Naspers Limited (ADR) (OTCMKTS:NPSNY) — has started to perform better. Its 14.6% return in the first half of 2017 is well ahead of Total Stock Market Index’s 8.9% gain. This positive momentum behind emerging markets suggests that the cycle may indeed be turning.
Of course, emerging-market investing is not without risk. Emerging Markets Index sustained a maximum cumulative loss of 62.7% in February 2009, from which it has yet to recover (despite its sizable gain between month-end February 2009 and April 2011). But then again, Total International Stocks Index only just recovered its own MCL of -58.50% in month-end May 2017.
If you’re a growth-oriented investor, this may be a compelling buy for a portion of your portfolio. Still, I recommend that you take your risk tolerance and investment goals into consideration when buying shares of this fund.
Vanguard Global Minimum Volatility (VMVFX)
If those options sound too risky for you, a more risk-controlled way to add foreign stocks to your portfolio could be Vanguard Global Minimum Volatility (VMVFX). But be aware that if foreign stocks really take off, this fund may not provide the same bang for your buck.
Launched in mid-December 2013, Global Minimum Volatility put up terrific numbers out of the gate when compared to its global counterparts. It’s only just approaching its fourth anniversary, but Vanguard’s version of risk aversion has worked over the past few years.
VMVFX’s 46.9% gain since inception through June 2017 is among the top 10 of all of Vanguard’s diversified stock funds — foreign or domestic. It was better than Vanguard Total World Stock Index Fund’s (MUTF:VTWSX) 28.8% advance, Total Stock Market Index’s 44.3% gain, as well as Total International Stock Index’s 14.7% return. Score one for Vanguard’s active management team.
Global Minimum Volatility’s secret is that it performed better versus its peers in down markets, thanks to the popularity of its low-volatility objective and the dollar’s strong climb.
Let’s take a look at the fund’s first 36 full months (or three years) of business — a rough time for international equities at large — and compare it to Total World Stock Index. From January 2014 to January 2017, there were 15 months when Total World Stock Index declined. During those months, VMVFX outperformed VTWSX by an average of 1.8%. In the other 21 months, when Total World Stock Index was up, its outperformance averaged just 0.5%. In fact, Global Minimum Volatility outperformed the index fund in up months about half the time. That’s impressive.
This year has interrupted VMVFX’s index-beating performance — up only 9% versus 11.6% for VTWSX through June 30. Outperformance may continue to fade if the currency hedge remains a headwind (read: if the dollar weakens). Additionally, the focus on lower-volatility stocks — including top holdings HDFC Bank Limited (ADR) (NYSE:HDB) and Jack Henry & Associates Inc. (NASDAQ:JKHY) — means that the fund may lag its international equity peers in up markets, and that’s what it has done so far in 2017.
If you’re an investor who simply can’t stomach another price-crushing decline, you might view the trade-off — the potential of slightly lagging competitors during up markets, but protecting your portfolio in down markets — as more than acceptable.
Editor/Research Director Jeffrey DeMaso helps publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds. As of this writing, he owned shares of Vanguard International Growth and Vanguard Emerging Markets Stock Index.