By Lewis Braham

With the U.S. stock market trading at generous levels, investors might consider moving some of their portfolio into less heady parts of the market.

International funds, for example. The popular MSCI All Country World Index ex USA foreign stock index -- which includes 22 developed and 24 emerging markets -- sports a comparatively modest 14.2 price/earnings ratio. The S&P 500 index's forward 12-month P/E is currently 22.9, about 30% higher than its long-term average.

A fund like Vanguard International Core Stock is a good way not only to play the MSCI benchmark's diverse international exposure but also to beat it. Though the $2 billion fund is actively managed, its country and sector weightings are similar to those of the benchmark. Yet it has outperformed the index by almost two percentage points annually since its October 2019 inception, having an 8.3% five-year annualized return and also an even lower 13.3 P/E for its portfolio, according to Morningstar.

In the past three years, the fund's 4.6% annualized return far outpaces the 1.9% average of its Morningstar Foreign Large Blend category, besting 92% of its peer group. Moreover, it has done this with less volatility and less downside risk than its peers, and its 0.48% expense ratio is low for an actively managed fund.

One can credit Vanguard for the low fees, but the outperformance is largely due to the fund's subadvisor, Wellington Management, which oversees some $1.3 trillion. Co-managers F. Halsey Morris and Anna Lundén have an immense pool of analytical resources they can access to find a small subset of stocks to beat the benchmark while not deviating too much from its sector and country weightings. They can draw on some 60 portfolio managers, 55 global industry analysts, 13 macroeconomic strategists, and 13 quantitative analysts.

Though its sector/country/style weightings are similar to the benchmark, the fund holds only 86 stocks, while the MSCI index holds 2,094. That means the fund's returns are almost entirely driven by stock-picking instead of sector and country bets. Moreover, even when Morris and Lundén buy a stock, their individual company weighting is typically within 0.5 and 1.75 percentage points of the benchmark's weighting of that stock, Lundén says.

Currently, "the largest deviation from the benchmark on the sectors in our universe" is about two percentage points, she says. "So we're not swinging for the fences in terms of our sector allocation. If you look below [the broad sector] level, you'll see us maybe deviate a little bit more. So, for example, within financials, at different points in time, we might favor the banks more than the insurance companies, or vice versa. But on the whole, the premise is to try to not get caught out by sector rotations or factor rotations."

Yet Morris and Lundén's portfolio is by no means static. The fund recently had a 76% turnover ratio, indicating that about three-quarters of its positions shifted in size or changed completely in the past year.

A number of new positions were added to the fund in 2024. This past March, as China was struggling with its economic doldrums, the team picked up HSBC, a British bank that does most of its business in Asia. "The bulk of their business and profitability really hinges on their performance in Hong Kong and other regional Asia markets," says Morris. "It's added to our U.K. weight, but really, we think about it as more a play on what's going to happen in China."

Unlike state-run banks domiciled in mainland China, HSBC isn't controlled by China's onerous regulatory regime. It has a "very solid balance sheet and at its valuation, which was about half tangible book [value], there was really a mispricing there," Morris says about the purchase's timing. The bank also "had the capital to get through a tough period."

In June, the team snapped up some tech stocks, such as Germany's SAP and Korea's SK Hynix. At 16% of the fund's portfolio, tech represents a small overweight over the benchmark's 14%. According to Morningstar, the fund has a slight overweight to Germany versus its fund category peers at 9.1% of its portfolio, but Lundén points to individual names such as enterprise software maker SAP as the reason, not any bets on Germany's economy.

"We invested in [SAP] because it's got a unique position in the software stack for most companies," Lundén says. "Its [software is] very sticky. Once you've got it, you'd rather cut off your arms than try and change things." The company is also shifting from selling on-premises installed software to more lucrative cloud-based software. "Because of their very sticky position with their customers, they can pretty much force their customers to do this," she says. "It's basically a shift that's going to help the margin profile of the company."

SK Hynix is a maker of memory chips, which are "largely a commodity product," Morris says, dependent on cyclical economic demand, but now there's a shortage. "We invested on the view that the cycle for the next couple of years is really going to be a tailwind, and that we're still early in that process. On top of the normal supply-demand dynamics...[Hynix has] a product called high-bandwidth memory, which is very well suited for the needs of data centers related to generative AI training."

Another purchase this June was MatsukiyoCocokara, which runs one of the largest pharmacy chains in Japan. One reason for the purchase, Lundén says, was to shift the fund's Japan focus from exporters, which had benefited from the weak Japanese yen increasing their sales to foreign countries, to more domestic-oriented businesses, as Japanese consumers now have more money in their pockets to shop because of recent wage inflation.

MatsukiyoCocokara is a stable company with "an opportunity to consolidate a very fragmented [mom and pop pharmacy] market, and they've got a strong balance sheet, like many Japanese companies," she says.

Such subtle portfolio shifts and smart active bets occur while the team still stays within the tight parameters of being a core fund. It's an impressive balancing act.

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November 01, 2024 21:30 ET (01:30 GMT)

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