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.
Many investors tend to favor funds that have recently done well. This habit is sometimes called “chasing performance” since these investors are constantly trying to get their portfolio to catch up with the results of the top funds. But is it an effective way to invest? That depends on whether funds that have done well in the past are more likely than other funds to do well in the future. And according to a recent study by Vanguard, that’s not the case.
The Vanguard study used simulations based on historical data from 2004 through 2013 to compare two different investing strategies. The first strategy involved selling funds that had underperformed during the past three years and buying funds that had outperformed. The second strategy involved simply holding onto the funds rather than buying and selling based on their recent performance. The study found that the second strategy did substantially better in every fund category that was tested.
The study doesn’t speculate on why chasing performance leads to poor results, but there are a few likely explanations. Funds that have done well may have benefited from a specific short-term trend in the market, such as good performance in a specific sector. If the fund manager’s approach always favors investments in this sector, the fund is bound to underperform once the short-term trend reverses. It’s also possible that the act of chasing performance itself hurts better-performing funds: as more investors shift into these funds, it’s harder for the funds to find good investments to make with all the new money.
The bottom line is that funds that have recently done well often aren’t the same ones that do the best in the future. Frequently buying and selling to replace underperformers with outperformers is a recipe for lower investment returns.
In a recent post we discussed the weak performance of Brazilian stocks over the past few years. But how do you know what your exposure is to Brazil (or any other country)? Unfortunately having only a general idea about the types of investments you own doesn’t answer that question.
Obviously if you own individual stocks in Brazilian companies, or a fund that invests solely in Brazilian stocks, those holdings will give you exposure to Brazil. But many other types of funds have Brazil exposure as well. Brazil makes up over half of the market value of Latin American stocks overall, so a fund designed to invest in Latin America will likely have a large exposure to Brazil. The same is true for broader emerging market funds: based on market value Brazilian stocks account for about 13% of emerging markets overall. More general international and global funds often have a small exposure to Brazil as well.
Yet even within these categories, the exposure to a specific country can vary dramatically. For example, the Invesco Developing Markets Fund and the iShares Emerging Markets Minimum Volatility ETF are both funds that invest in emerging market stocks. Yet Brazilian stocks make up almost 20% of the former and only about 6% of the latter. Furthermore, these numbers will change over time as markets move and as the fund managers change their views about which stocks they should be invested in.
There are even more dramatic differences for other countries. The two largest emerging markets funds by assets, the Vanguard Emerging Markets ETF and the iShares Emerging Markets ETF, are both “passive” funds that simply try to mimic a benchmark index of stocks. But they’re far from identical. Because they have different definitions of which countries qualify as emerging markets, South Korea is the largest country in the iShares fund and has a 0% weighting in the Vanguard fund.
For most investors, taking the time to investigate these details for every holding isn’t a reasonable option. Instead, having tools that allow you to easily understand your geographic exposure and let you know when it gets out of alignment can be a better alternative.