VEA - VEA: Inferior Growth Profile And Limited Downside Protection

Summary

• Vanguard FTSE Developed Markets ETF owns a portfolio of large-cap stocks in developed markets outside of the U.S.
• The fund’s price may continue to be depressed in the near term due to the Federal Reserve’s policy.
• VEA has an inferior growth profile than the S&P 500 Index and offers limited downside protection.

ETF Overview

Vanguard FTSE Developed Markets ETF ( VEA ) invests in large-cap stocks in developed markets, not including the United States. The fund basically tracks the FTSE Developed All Cap ex U.S. Index.

VEA has trailed the S&P 500 Index (SP500) since its inception due to its low exposure to the technology sector. In an economic downturn, the fund also appears to have a slightly higher downside risk than the S&P 500 Index. Therefore, we do not see the need to own this fund in the long term. In the near term, its fund price will likely be range-bound due to the Federal Reserve's policy to keep the rate elevated for a lengthy period. Therefore, we think investors should seek alternatives elsewhere.

Fund Analysis

Poor performance in 2022

VEA performed poorly in 2022 due to the Federal Reserve's aggressive rate hikes to combat inflation. Between the peak reached in January and the trough in October 2022, the VEA fund delivered a return of about negative 29%. The rebound towards the end of last year has helped the fund recoup some of the losses. Nevertheless, VEA still saw a decline of nearly 18% in its fund price in 2022.

Will 2022 repeat again in 2023?

One indicator that we pay attention to when considering investing in stocks outside of the United States is to look at the strength of the U.S. dollar. A strengthening U.S. dollar will attract money from other countries towards the United States. Therefore, foreign equities and bond assets tend to fall when the U.S. dollar strengthens. On the contrary, a weakening U.S. dollar will cause money outflow from the United States towards other markets in the world. In this case, equities and bonds in foreign markets tend to rise in value. As can be seen from the chart below, VEA's fund price has an inverse correlation with the strength of the U.S. dollar.

To answer the question of whether 2023 will be as brutal as 2022 basically depends on the strength of the U.S. dollar. Therefore, we need to look at the main force that causes the U.S. dollar to strengthen or weaken: the Federal Reserve's monetary policy. Last year was the year when the Federal Reserve had to raise the rates aggressively in order to tame inflation. The consequence of this was a strengthening U.S. dollar. Hence, we saw a decline in VEA's fund price.

Since inflation has proven to be quite sticky based on recent retail, core PCE, and wage growth data in the past month, we do not think the Federal Reserve is near the turning point to lower its rate. In fact, we see that the Federal Reserve will continue its rate hike trajectory and raise the rate perhaps by 25 basis points in each of its 3 remaining meetings in the first half of 2023. Whether it will stop its rate hike or not depends on the inflation data in the next few months. Even if the Federal Reserve decided to stop raising rates, any rate drop will likely be a story beyond 2023 at least. This is because inflation can be very sticky and to bring inflation down to sub 3% level will take quite a bit of effort and time. An elevated rate means that the U.S. dollar will remain strong. Hence, it may not be easy to have any meaningful rebound of VEA's price in 2023.

VEA has an inferior growth profile

VEA has underperformed the S&P 500 Index in the long run. In fact, in the past 10 years, the S&P 500 has delivered a total return of about 214%. On the contrary, VEA only delivered a much inferior total return of 64%.

This underperformance is due to VEA's low exposure to high-growth sectors such as the technology sector. As can be seen from the table below, the technology sector only represents 9.73% of VEA's total portfolio. This is much lower than the S&P 500 Index's 23.73%.

As can be seen from the table below, VEA's earnings growth rate of 8.4% was less than half of the 17.8% growth rate of the S&P 500 Index. This inferior earnings growth rate also impacted the fund's return on equity. ROE for VEA was also about half of the S&P 500 Index.

Source: Vanguard Website

Downside risk is also high

A slower average earnings growth rate is acceptable if the fund provides stability and better downside protection. However, if we look at VEA's past history, we found otherwise. As can be seen from the chart below, the fund has declined over 60% from its peak during the Great Recession in 2008/2009. On the contrary, the S&P 500 Index declined by about 55% during the same period. The fund also declined more than the S&P 500 Index in last year's bear market. Given the fact that the fund has delivered a much inferior total return than the S&P 500 Index, and has high downside risk in an economic downturn, we do not see the reason of owning this fund.

Investor Takeaway

Vanguard FTSE Developed Markets ETF appears to have an inferior growth profile than the S&P 500 Index. In addition, downside risk remains high in an economic recession. Hence, we do not think it is necessary to own this VEA fund for the long term. Its near-term outlook is also uncertain due to the fact that the Federal Reserve will likely keep the rate elevated for a lengthy period of time. Therefore, investors may want to find alternatives elsewhere.

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