Vanguard International Growth is looking to emerging markets for growth.

For Virginie Maisonneuve, China is more than a country with a burgeoning economy and red-hot stock market. "I consider China a passion," says the 42-year-old manager of the Vanguard International Growth Fund.
If the 97% rise in China's most widely traded stocks last year is any indication, a lot of investors share those warm feelings. But Maisonneuve's interest began back when a mysterious veil of secrecy still shrouded the country. As a young child growing up in France during the 1970s, she knew that she would "always be associated with China in some way." She fulfilled that premonition in the mid-1980s when she attended an intensive Chinese foreign language institute, and later began her career as a consultant with the French Ministry of Foreign Affairs in China. Her two adopted daughters are Chinese.
In the fund, Maisonneuve's positive feelings about the country's investment potential translates into investments in its stocks, such as cell phone maker China Unicom, as well as stocks of other emerging market countries such as Indonesia, Russia, India and Brazil. Altogether, emerging market stocks account for roughly 13% of the $15.3 billion fund's assets. The allocation was up to 20% in September, but Maisonneuve and co-manager Matthew Dobbs decided to take some profits and trimmed the allocation late in the year.
Those profits came after a severe plunge in May and June as foreign investors, concerned about rising interest rates, fled emerging markets and prompted a decline of 25% in the Morgan Stanley Capital International Emerging Markets in just over a month. That index later rallied and ended the year nearly 30% higher. For investors willing to ride out such volatility, Maisonneuve considers emerging markets the "best place to find new investment opportunities that have growth potential and are attractively valued."
Despite that conviction, those markets are not the centerpiece of International Growth's carefully controlled, risk-averse portfolio. Established Europe accounts for 60% of assets, and the Pacific Rim another 25%. Two countries, the U.K. and Japan, account for nearly 44%. There are no big individual stock bets here, with 140 stocks in the portfolio and the ten largest holdings weighing in at 18% of assets. To help control risk the fund is usually not less than half-weighted, or more than one-and-one-half times weighted, the "major components" of its benchmark, the MSCI EAFE Index. A major component is any region, sector or country with a 20% weight or more.
Maisonneuve's employer, London-based Schroder Investment Management, advises roughly two-thirds of the fund, with James Anderson at Baillie Gifford Overseas in Scotland stewarding the rest. She took over as manager after the 2005 retirement of Richard Foulkes, the former vice chairman of Schroder. Like her predecessor, she favors a value-conscious, growth-at-a-reasonable-price style. Baillie Gifford employs a more classic growth strategy by looking for stocks with above-average earnings and cash flow and the potential for positive earnings surprises.
It's hard to say whose side is doing better, since Vanguard does not disclose separate returns for each firm's assets under management. A Morningstar report on the fund notes that Maisonneuve has "thus far been able to fill the shoes of her predecessor," while James Anderson "assembled a strong track record at the U.K.-based fund Baillie Gifford International." However, it also goes on to say that the latter firm "has a mediocre record on a mutual fund it runs for Guardian, though that fund is pricier and has a narrower mandate than this one." Maisonneuve reserves comment, saying only that the two firms have complementary styles that mesh "with a lot of harmony and cohesion."
For its sleeve of the portfolio, the Schroder investment team uses fundamental analysis to rank stocks from "one," which is a strong buy, to "four," a strong sell. They also consider macroeconomic factors, including oil prices and interest rates, as well as local and regional conditions. Business and consumer trends in the U.S. come into play for companies with a large consumer base in this country, such French dairy and beverage firm Danone.
Long-term core holdings make up about 70% of the 70 to 90 names in the portfolio and typically stay in the fund for several years. The rest of the portfolio consists of  "opportunistic" investments with timely themes that have a shorter holding period.
Over the last few years, cyclical stocks in economically sensitive areas such as energy and materials have dominated the opportunistic side. But Maisonneuve contends that at this point in the economic cycle those sectors are more vulnerable than growth stocks. "We believe that market leadership has shifted to favor quality growth investing and we are refocusing the portfolio accordingly," she says. "We've sold some of our industrial holdings, and to be fair we may have gotten out a bit too early. But they were getting close to their fair market value and we think there are better opportunities elsewhere."
The fund's more defensive leanings toward companies with steady earnings growth is in response to the delicate balancing act many of the world's economies are performing, she says. Her firm is looking for deceleration in global gross domestic product from 3.5% in 2006 to 2.9% this year. Potential economic stumbling blocks over the next year include decreasing property values, higher oil prices, slowing consumer demand and continued tension in the Middle East. "I'm also worried about the consensus view that oil prices will go down. We need to keep in mind that demand for oil in China will double over the next ten years. By the end of this year the country will still only have one month of oil reserves." If oil stocks continue to drop, she says, she may step in as a buyer.
Counterbalancing those concerns is the support provided by the money from the Middle East, China, and Russia flowing into everything from property to brand-name shoes. "I live in London and I can tell you that the property market here is not supported by the British, but by wealthy investors from the Middle East and Russia," she says. "The liquidity coming from these emerging markets is sustaining demand."
Like the world's economies, financial markets are searching for balance as well. "Valuations are not stretched, but we need to keep an eye on profit growth," she cautions. "We've had some amazing earnings growth over the last three or four years, but pricing power is not all that great and wage growth is tame. Investors are going to react sharply to earnings surprises, and we are likely to see more volatility in the world's financial markets this year than we did in 2006."
Maisonneuve is looking to a number of consumer staples stocks to add some ballast to the portfolio. One of them, Danone, is launching higher-calcium products that should boost sales and is well-positioned to benefit from a stable business in the U.S. and Europe and growth in developing markets. U.K. retailer Tesco, which offers a broad range of products, is a core holding with a growing online business in its home country as well as Eastern Europe and China. Another U.K. core holding, Burberry, makes luxury handbags, coats and other apparel. A new CEO came over from another well-known clothing label and is looking to expand the company's presence in the U.S. accessories market.
Two banks in Europe have also caught her eye. One of them, Societe General, is expanding its niche from the French market into nearby Eastern Europe with mutual fund and insurance products that many consumers are buying online. Italy's San Paolo Bank has a valuable insurance franchise that the market is not recognizing.
For Vanguard fans, the question is whether to go with actively managed International Growth or another all-in-one international offering that includes emerging markets, Vanguard Total International Stock Index. Both have low expense ratios-0.55% for International Growth and 0.32% for Total International Stock Index. Both are about as volatile as the MSCI World Index Ex USA, which includes both established an emerging markets. Total International, which combines the firm's European, Pacific and Emerging Markets stock index funds, is classified as a foreign large blend fund, while International Growth falls into the foreign large growth category. The turnover rate for International Growth is 45%, compared to 2.1% for Vanguard Total International Stock Index.
In terms of pretax performance the index fund holds a slight edge over the one- and three-year periods, and a 2.3 percentage point lead over the five years ending December 31. On an after-tax basis, Total International's and International Growth's respective returns were 26.04% and 23.43% over one year, 20.4% and 18.69% over three years, 15.51% and 12.92% over five years and 7.14% and 7.07% over ten years.
It's hard raising a bar you've set yourself, but that is what Vanguard faces when it comes to measuring the performance of its actively managed funds against its passive index offerings. For International Growth and many funds sponsored by Vanguard and other fund firms, beating those bogeys, especially on an after-tax basis, remains a challenge.