What the Changes to Your Vanguard EM Fund Mean

China Performance

Vanguard recently announced changes in the investments that some of its funds will hold. Perhaps the most significant of these changes are the ones that affect your Vanguard emerging markets index fund. The fund will add both exposure to smaller companies and exposure to Chinese companies whose shares are listed on stock exchanges in mainland China.

Including smaller companies is a change that Vanguard is making in many of its international funds. The stated reasons for the switch are to make investors’ exposures more in line with the overall market and to increase the diversification of their funds’ investments. These reasons make sense, since when you buy an index fund tracking the performance of a particular market, you generally expect it to track as much of that market as possible.

Stocks of smaller companies tend to be more volatile than stocks of larger companies, and they can also be affected by different economic factors. In emerging markets, for example, companies in the energy, communications, and financials sectors are a much smaller portion of the market among small companies than large ones.

The change to include Chinese stocks listed on stock exchanges in mainland China (often called “A-shares” as opposed to the “H-shares” of Chinese companies listed in Hong Kong) may be even more interesting given what’s happened in Chinese markets recently. As the graph above shows, starting in May the performance of the A-shares dramatically diverged from the H-shares. The A-shares soared until the middle of June and then plunged while the H-shares gradually declined.

Part of the divergence is caused by the companies listed in mainland China often not being the same as the companies listed in Hong Kong. But even A-shares and H-shares of the same company can behave very differently. A-shares have tended to be more volatile than the H-shares, and the disparities have increased in the past year.

According to Morningstar the small company change and the China change will combined affect only about 15% of Vanguard’s emerging markets fund, so they shouldn’t substantially alter the fund’s performance. Most of the fund will still be invested in larger companies, and Chinese companies listed in Hong Kong will still be a much larger portion of the fund than Chinese companies listed in mainland China. The only difference investors may notice is that by the time Vanguard finishes implementing the changes (which will be sometime next year), the fund will be slightly more diversified and possibly slightly more volatile.

The Lesson of the Swiss Franc Surge

Swiss Franc

Last week Switzerland’s central bank shocked financial markets by removing the cap it had set on the value of the country’s currency, the Swiss franc. As a result the value of the franc surged more than 20% against the US dollar.

Switzerland comprises less than 4% of the global stock market, so for most American investors who aren’t currency speculators the surge didn’t directly have a large impact on their portfolios. But it was later revealed that a hedge fund, Everest Capital’s Global Fund, was essentially wiped out by the currency swing. And there were likely a number of other funds that were buffeted as well.

The travails of such funds highlight the importance of knowing what you own in your portfolio. “Knowing what you own” doesn’t mean memorizing the names of all your holdings or learning facts about each one. Instead it means having a high-level understanding of how the different pieces of your portfolio fit together: which asset classes, sectors, and regions of the world your portfolio is exposed to.

Having a clear understanding of these exposures can help ensure that your portfolio won’t be decimated when the price of some asset swings wildly, as occasionally happens. A sudden 20% movement for a currency as prominent in the global economy as the Swiss Franc is extremely rare. But with so many possible occurrences in financial markets, outcomes that individually seem like they should be rare actually happen fairly frequently. The price of a major commodity such as oil falling by 50% in a 6-month period is also a rare occurrence, for example, but such a plunge happened in the second half of 2014 (and an even larger one occurred only 6 years earlier, in 2008).

Trying to predict each one of these rare events would be a fool’s errand. Knowing what you own, and therefore being able to avoid any concentrated exposures that could ravage your portfolio, is a simpler and more rewarding alternative.