(PUB) Investing 2016

Japanese stocks and another 25% or so in Australian and Korean stocks, when those markets are closed and there is major market-moving news occurring in those countries while U.S. markets remain open. The difference between the price of a fund’s regular shares and its ETF shares can sometimes tell the tale of a Vanguard intervention. For instance, Emerging Markets Stock Index’s daily return and the return of its ETF shares have varied by as much as 1.0% to 2.2% on a handful of days since the start of the year. Differences between ETF and open-end fund performance tend to even out within a day or two, and unless you’re trading in and out of the open- end fund, which Vanguard will quickly put a stop to, I wouldn’t lose a wink of sleep over fair-value pricing. With all of that said, and with July’s primer on investing overseas as backup, here’s where Vanguard stakes its for- eign investing claims, and where Dan and I suggest you focus your purchases. Developed Markets Index Sell. Once a fund of funds, Developed Markets Index now holds individual stocks, just like the rest of Vanguard’s foreign funds. While the benchmark the fund tracks has changed over time, and completed its latest transition in June, the fund’s mission remains the same: Track a broad set of stocks from established foreign markets. The new index the fund tracks, the FTSE Developed All Cap ex-U.S. index, includes smaller stocks as well as Canadian stocks, something the fund did not hold in previous incarnations. Based on his- torical data, these additions added to performance over time, though vola- tility also increased. As you might expect, Developed Markets Index does not hold stocks from emerging market countries, which you will find in other index funds like Total International Stock Index, Total World Stock Index or World ex-U.S. Index . And there’s the rub. If you buy into the indexers’ credo that one should index “all” markets rather than a slice of the pie, then this fund is a non-starter.

Emerging Markets Stock Index Hold. Also proceeding towards a new benchmark, the FTSE Emerging Markets All Cap China A Inclusion index, this fund is unique in making a foray into the volatile and opaque A-shares market of mainland China. Vanguard has already said that it’s going to have to deviate from the index by “sampling” rather than “rep- licating,” and this new index will be a moving target due to the limits that the Chinese government puts on foreign entities’ ownership of A-shares. Still, this isn’t as big a change as the press would have you believe. While the small caps being added to this fund should increase volatility, exposure to China should only grow by about 3% from where it stood a year ago, to 30%. Additionally, Vanguard is taking its time implementing this change and has been tracking a “transition” index since last November. The conversion should be completed in the fall. The emerging markets are consid- ered a global growth engine, but they’re also riskier than mainstream domestic markets. And China’s slowdown, which was big news at the start of this year but has taken a back seat to terrorism and politics, begs the question of whether the risk-return balance favors returns as much today and tomorrow as it has in the past. More broadly speaking, are the large-cap domestic companies you own today already giving you enough exposure to emerging markets through their global operations, or do you need direct exposure to companies in these regions? I lean toward the latter, and a fund like International Growth gives us good exposure. A small allocation to emerging markets makes sense, as there will always be local companies that will understand and be able to take advantage of local markets in a fashion the bigger global conglomerates won’t. Additionally, while it may feel like stocks across the globe all move in the same direction on a day-to-day basis, in fact, emerging market stocks can be good diversifiers over time. Consider that from the end of 1999 through 2007, Emerging Markets Stock Index gained

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stocks for the long term makes good portfolio sense. This is the perfect time, then, to review Vanguard’s lineup of foreign stock funds, a host of rather basic offerings, with a slew of overlapping index funds and a handful of active funds. While developed and emerging markets are well represented, frontier markets, home to riskier but potentially faster-growing fare, haven’t made it onto Vanguard’s list yet. I don’t expect to see them soon, either. With over $3 trillion in assets under management, it takes a large opportunity to move the needle for Vanguard, and the small size and limited liquidity of frontier markets don’t offer much motivation to launch a new product. In fact, there hasn’t been much excitement surrounding Vanguard’s foreign lineup, save for the addition of smaller stocks to its core index funds, along with a growing allocation to mainland China A-shares in Emerging Markets Stock Index. While it raised a lot of eyebrows when first announced, the China news has fallen from inves- tors’ radars. This is just as well. As Dan and I wrote in the July 2015 issue, for all the noise this change generated, the impact was pretty small. Last month we talked a lot about investing overseas and whether it makes sense to conform to Vanguard’s recommended 40% (of equities) allo- cation to foreign stocks at all times or to allow the markets and your head and stomach to determine an appropriate allocation. One thing we didn’t discuss was the actual funds themselves. So, let’s do that. But first, I want to mention something called “fair-value pricing,” which is the day-to-day manipula- tion of mutual fund prices (not ETF prices) that Vanguard engages in (as required by the SEC) to prevent inves- tors from leaping ahead of news events that may cause market moves in time zones many hours different from our own. Investors might, for instance, try to trade Pacific Index , which has about 60% of its assets allocated to

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