Summary VPL has a respectably low correlation to SPY and isn’t too volatile in its own right. The expense ratios are low and the liquidity is strong, but the ETF is currently trading at a premium to NAV. Despite the name, China is almost completely excluded while Japan and Australia dominate most of the portfolio. Investors should be seeking to improve their risk-adjusted returns. I’m a big fan of using ETFs to achieve the risk-adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. A substantial portion of my analysis will use modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. In this article, I’m reviewing the Vanguard FTSE Pacific ETF (NYSEARCA: VPL ). What does VPL do? VPL attempts to track the investment results of the FTSE Developed Asia Pacific Index. The ETF falls under the category of “Diversified Pacific/Asia”. Does VPL provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large-cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I start with an ANOVA table: (click to enlarge) The correlation is about 77%, which is low enough that I’m expecting to see significant diversification benefits. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation isn’t too bad. For the period I’ve chosen, the standard deviation of daily returns was .889%. For SPY, it was 0.736% over the same period. While VPL is more volatile than SPY, the difference isn’t huge enough to prevent the low correlation from reducing portfolio risk if the level of exposure is right. Mixing it with SPY I also run comparison on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and VPL, the standard deviation of daily returns across the entire portfolio is 0.764%. If the position in SPY is raised to 80% while VPL is used at 20%, the standard deviation of daily returns drops down to 0.734%. This is slightly below the standard deviation of a portfolio that only holds SPY. In practice, I would want to limit a position in VPL to no more than 20% of the portfolio, but I’d prefer to use an amount that was still lower. The low correlation makes a very strong case for using VPL in a small position to enhance diversification. At 5%, the standard deviation of the portfolio would have been 0.733%. If an investor was only measuring risk based off the standard deviation of returns, it would appear that the 20% to 5% range was very reasonable. I’d lean towards being a little more conservative with the exposure. I think 10% to 5% is a fairly reasonable range. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Yield & Taxes The distribution yield is 2.7%. It’s high enough that the portfolio could be included as part of an ETF portfolio designed for a retiring investor. If an investor wants to ensure they aren’t tempted to get into the portfolio, the strong yields are nice. Expense Ratio The ETF is posting .12% for an expense ratio, which is a very reasonable cost for the diversification. Unfortunately, most ETFs have expense ratios higher than I’d like to see. Clearly, VPL isn’t one of those ETFs. Vanguard funds usually have low expense ratios, which is one of the more appealing things about using their ETFs. Market to NAV The ETF is trading at a .22% premium to NAV currently. I think any ETF is significantly less attractive when it trades above NAV. I wouldn’t have expected such a significant premium on an ETF with over a million shares per day trading hands. I may need to dig deeper into the ETF to look for a reason for that premium and determine if it is normal for the ETF to trade at a premium. Aside from that premium, this is one of the better foreign ETFs I’ve seen. Largest Holdings The diversification within the ETF is pretty good. Despite the largest position being over 3%, the allocations drop off rapidly before we are even out of the top 10. I find that attractive because it ensures investors are getting some diversification benefits within the individual holdings as a benefit for paying the expense ratio. (click to enlarge) Investing in the ETF is largely relying on modern portfolio theory. The argument for the investment is the respectably low correlation of the portfolio to the major U.S. index funds. Making an investment requires a belief that markets are at least somewhat efficient so that the companies within the portfolio will be reasonably priced. Conclusion The ETF looks less volatile than many of the foreign ETFs I have been considering. I’m finding that to be an attractive factor even though there is significant correlation between VPL and the other international market ETFs. So far, VPL is easily one of the stronger contenders for the foreign exposure area in my IRA. The ETF simply does very well on several metrics. Toyota (NYSE: TM ) is a very solid company to have as the top holding. The most interesting thing I found while researching the ETF is that the exposure isn’t quite what I would have expected when broken down by individual countries. I figured Japan would be a significant part of the portfolio, but being over 50% of the portfolio is enough to concern me a little bit. Despite the strong focus on a single foreign country, the volatility has been much lower than competing ETFs with much broader focuses. Australia is the second largest representation at nearly 20%. That’s okay with me. BHP Billiton (NYSE: BHP ) is a quality company that I’d have no issue with having in my portfolio despite the terrible performance lately of mining stocks. Hong Kong is represented with 7% of the portfolio, but China is less than 1%. When I’m looking at something labeled “Asia Pacific”, I generally expect substantially more Chinese companies to be included. If I had commission-free trading on VPL so I could keep rebalancing the position for free, it would be a pretty much automatic pick for my foreign exposure. In that hypothetical scenario, I’d lean towards a 5% exposure. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.