International Indexing - A Better Mousetrap

Last Updated Oct 21, 2010 11:04 AM EDT

On September 24, Vanguard announced a new index for its Total International Index Fund (VGTSX). Instead of following the MSCI EAFE + Emerging Markets index, it will now be following the MSCI ACWI ex US index. This may seem like only a technical change, but it's actually a huge change for the good. When implemented, it will be my recommended vehicle for international investing.

History of International Indexing
International indexing has been around for quite some time. The first funds were known as EAFE funds, such as the Fidelity International Index Fund (FSIIX), and included only Europe, Australia, and the Far East. Missing were the emerging market countries, Canada, and small cap companies from every country. Next came funds like the Vanguard Total International Index Fund (VGTSX), which included the emerging market countries, excluding Canada, which represents about seven percent of the international stock market.

Then, in March 2007, The Vanguard FTSE All World Ex-Us (VEU) ETF launched and gave access to Canada. The launch of completion indexes followed, giving access to small cap international stocks.

Finally, the fourth generation of international indexing
Vanguard builds the better fund
Rather than starting from scratch and launching a new index fund, Vanguard took its current second generation VGTSX fund and changed the index to that of a fourth generation fund. This gives the fund two advantages from the investor's perspective:

1. VGTSX is currently at $27.8 billion in assets, making the sampling of small cap stocks much more efficient, which should lower tracking error.

2. Vanguard will be launching ETF class shares that will have a 0.20 percent annual expense ratio. This compares to a 0.35 percent annual expense ratio for the iShares ACWX. The symbol has not yet been announced.

So the next generation of international index funds is coming and large enough to actually own the rest of the world. The chart below shows the broadness of this fourth generation fund compared to the previous three.

Back to owning the world with two funds
For many years, it's been easy to build a total US portfolio with one fund such as the Fidelity Spartan US Index Fund (FSTMX) or the Vanguard Total Stock Market ETF (VTI). Building a total international portfolio, however, has not been so easy. When Vanguard completes this index change, the Vanguard Total International Index fund and ETF will be the easiest and least expensive way to build the broadest of the international index funds.


Author's note: the original version of this blog incorrectly stated that the iShares ACWX ETF had small cap exposure. Originally, it did but MSCI changed the composition of the index.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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