An Attractive European ETF For Intrepid Investors

| About: Vanguard FTSE (VGK)

By Alex Bryan

Europe is fraught with risk. Unemployment is close to 11%, fiscal imbalances in Spain and Italy threaten to drag down the rest of the eurozone, and austerity measures could keep demand soft for years. Yet, recent Markit Purchasing Manager Index data suggests that the region is starting to stabilize. Macroeconomic news is typically quickly incorporated into stock prices. However, Vanguard FTSE Europe ETF (NYSEARCA:VGK) is one of the best options for investors who believe that this nascent recovery will gain traction. While not for the faint of heart, its holdings are trading at reasonable valuations and may grow faster than their U.S. counterparts as conditions in Europe improve.

The fund invests in large- and mid-cap stocks based in 16 developed European markets, representing most of the investable market. However, British and Swiss stocks account for nearly half the portfolio. While the fund has limited direct exposure to the weakest members of the eurozone, the health of these markets may have a disproportionate influence on its performance. This is the cheapest broad European stock fund with one of the most comprehensive portfolios available. Consequently, it is our pick for passive exposure to European equities and is a suitable core holding. The fund's largest holdings are quality multinational names, such as Novartis (NYSE:NVS), Vodafone (NASDAQ:VOD), Total (NYSE:TOT), and Nestle (OTCPK:NSRGY).

European stocks can offer meaningful diversification benefits to U.S. investors. The FTSE Developed Europe and Russell 1000 Indexes were 0.90 correlated over the past decade. The fund offers greater exposure to basic-materials stocks than most broad U.S. funds, which tend to underrepresent them. It also owns more financial-services stocks. While European banks still face significant risks, these stocks may enhance the fund's diversification benefits. Like most international funds, VGK does not hedge its currency exposure. Consequently, it may help hedge against a decline in the value of the U.S. dollar relative to the euro and pound sterling.

Fundamental View
Europe has a long way to go to resolve structural imbalances and establish a sustainable growth trajectory. Deleveraging in the public and financial sectors has created a significant drag on the region's growth. Weakening demand for European goods and services has intensified price competition. In order to control costs, firms have laid off workers and cut back on hiring, resulting in an unemployment rate of 11% across the European Union. This high unemployment rate contributes to the vicious cycle of weak demand as consumers cut discretionary spending.

The risk of a prolonged recession, coupled with high and growing levels of government debt, has led to a series of sovereign credit downgrades across the region. Moody's downgrade of U.K. sovereign debt in February demonstrates that even the strongest European countries are not immune. But the possibility of an outright default looks increasingly remote, particularly in light of the European Central Bank's commitment to make unlimited purchases from troubled euro countries that apply for aid.

There are also some signs of improvement. Business activity across the eurozone has expanded for three consecutive months through September, according to Markit Purchasing Manager Index (PMI) Survey data. New business helped drive this growth. Business confidence is also starting to come back. This improvement in demand has helped reduce the number of job losses, though the labor market remains weak. Preliminary PMI survey data for October suggests that the expansion continued this month. Germany has generally held up the best of the major markets, while France, Italy, and Spain remain on precarious footing.

The U.K. has especially shined. According to PMI survey data, the British services sector expanded at the fastest clip in over 15 years during the third quarter of 2013 and posted its ninth month of consecutive growth in September. Sales grew as confidence picked up. Work backlogs increased, and service businesses expanded their payrolls to adjust. The manufacturing and construction sectors are also recovering. September marked the sixth and fifth consecutive month of growth for manufacturing and construction, respectively. Renewed strength in residential construction bodes well for British banks.

European companies are less likely to enjoy durable competitive advantages than their U.S. counterparts. Of the fund’s holdings that Morningstar equity analysts cover, only 23% by market value carry wide economic moats, Morningstar’s assessment that a firm enjoys a sustainable competitive advantage. The corresponding figure for the Russell 1000 Index is 43%. Perhaps not surprisingly, European companies are also slightly less profitable. Over the trailing 12 months through September, the constituents in the FTSE Developed Europe Index generated a 10.9% return on invested capital, while those in the Russell 1000 Index posted 12%. But the fund's holdings may generate faster earnings growth if demand continues to strengthen over the next few years.

Although many risks remain, the fund offers attractive compensation. As of the end of September, the stocks in the fund's benchmark offered an estimated dividend yield greater than 3%, and were trading at a lower average price/forward earnings multiple (14) than the Russell 1000 Index (15.6). Consequently, VGK may offer a more attractive risk/reward profile than many broad U.S. funds.

Portfolio Construction
In March, Vanguard transitioned the fund from the MSCI Europe Index to the FTSE Developed Europe Index, citing potential cost savings. These indexes both cover the same countries and offer very similar exposure. The FTSE index targets large- and mid-cap stocks based in developed markets in Europe, including Switzerland and the U.K. It ranks stocks' market capitalization and selects the largest for inclusion until it covers 86% of the investable universe. In order to limit turnover, FTSE permits existing constituents to remain in the index as long as they fall in the top 92% of the European investable market by market cap. FTSE weights each constituent in the index by its free-float adjusted market capitalization. It reconstitutes the index annually in September. Top country weightings belong to the U.K. (33%), Switzerland (14%), and France (14%). The fund has limited direct exposure to the weakest members of the eurozone. For instance, together Italian and Spanish stocks account for less than 8% of the portfolio. Relative to the Russell 1000 Index, VGK has greater exposure to basic materials, financials, and consumer defensive stocks and significantly less exposure to the technology sector.

Vanguard is usually hard to beat on fees, and this fund is no exception. It charges a rock-bottom 0.12% expense ratio, making it the cheapest U.S.-listed European ETF. It also offers good liquidity, which should make it cheap to trade. Vanguard engages in securities lending, the practice of lending out the fund's underlying holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses.

Nearly 90% of VGK’s portfolio overlaps with its closest alternative, iShares Europe ETF (NYSEARCA:IEV). But its 0.60% expense ratio is a deal-breaker. Investors looking for pure exposure to the European Monetary Union might consider iShares MSCI EMU Index (BATS:EZU), which only holds stocks listed in countries that have adopted the euro. EZU’s exclusion of British and Swiss stocks makes it riskier than VGK, but it may also offer a little better upside if a recovery gains traction. Unfortunately, EZU charges a relatively high 0.53% expense ratio. SPDR EURO STOXX 50 (NYSEARCA:FEZ) (0.29% expense ratio) is a cheaper, but more concentrated, eurozone option. FEZ rests on a narrow base of 50 blue-chip companies.

BlackRock offers a suite of iShares products that track individual European countries, such as iShares MSCI United Kingdom (NYSEARCA:EWU) (0.53% expense ratio), iShares MSCI Germany (NYSEARCA:EWG) (0.53%), and iShares MSCI France (NYSEARCA:EWQ) (0.53%) among others. Although they are more expensive than VGK, these funds are ideal for investors who want direct control over their country allocations.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.