The Vanguard FTSE All-World ex Canada (VXC) allows Canadians to get access to US, international and emerging markets equities with a single ETF, and it’s one of the ingredients in my model portfolios. Vanguard recently announced some planned changes to VXC’s benchmark index, so let’s take a closer look.
Right now, VXC holds only large and mid-cap stocks, but it will soon be adding small-caps to the mix—at least for overseas markets. This will come about indirectly as a result of changes to the benchmark indexes of three of the fund’s underlying holdings.
VXC gets exposure to international developed and emerging markets through three US-listed ETFs: Vanguard FTSE Europe (VGK), Vanguard FTSE Pacific (VPL) and Vanguard FTSE Emerging Markets (VWO). These will soon begin tracking new “all cap” indexes that include small companies as well as large and mid-caps. Vanguard estimates that small-caps will eventually make up about 10% of each ETF. To reflect these changes, VXC will receive a new name: the Vanguard FTSE Global All Cap ex Canada Index ETF.
But it’s not clear whether VXC will add small-caps to its US equity exposure. The ETF currently tracks the US markets using the Vanguard Large Cap (VV). Given the fund’s new “all cap” mandate, I asked Vanguard whether VXC would be substituting the Vanguard Total Stock Market (VTI), which also includes mid and small-caps. The answer was no, though “over time we may consider alternatives that enable us to achieve exposure beyond what VV provides.”
There’s actually a good reason for this decision. Selling VV and buying VTI today could result in unitholders being slapped with a large capital gain distribution: VV makes up more than half of VXC, and it’s up about 28% (in Canadian dollars) over the last 12 months. Investors holding VXC in taxable accounts would pay a steep price for a switch to VTI.
With concerns like this in mind, Vanguard won’t be implementing the proposed changes all at once: the small caps will be added gradually over several months “to ensure an orderly and cost effective transition.” The changes are not expected to trigger capital gains, and there will be no changes to the funds’ management fees.
Canadians who use Vanguard’s other TSX-listed funds for international equities—both developed and emerging markets—will also be affected by these index changes: the Vanguard FTSE Developed ex North America (VDU), its currency-hedged counterpart VEF, and the Vanguard FTSE Emerging Markets (VEE) will be getting small-cap exposure, too. This will bring these ETFs close to their competitors, the iShares Core MSCI EAFE IMI (XEF) and iShares Core MSCI Emerging Markets IMI (XEC). The iShares ETFs already track “investable market indexes,” which is MSCI’s term for what FTSE calls an “all cap index.”
I see these changes as a positive development, for at least two reasons. First, small-cap stocks have historically delivered higher returns than large and mid-cap stocks in most countries. Second, funds that hold stocks of all sizes tend to have very little turnover, which means taxable capital gains distributions are less likely.