Rob Arnott, chairman of the Pasadena, Calif.-based investment advisory Research Affiliates--who with FTSE has devised 40 international ETFs marketed through various distributors including PowerShares--has championed an approach that integrates revenues, cash flow, book value along with dividends in devising his indices. Arnott claims that “relying on just dividends leaves out too much of the market and ends up producing portfolios that are heavily tilted to financials and utilities.” His international equivalent is the FTSE RAFI Developed Ex-US 1000 Index.  It basically matched EAFE over the past year, and outperformed the index over the trailing 3 and 5 years through August.

So is EAFE the most effective way to direct assets overseas or are there better means for investing in developed foreign markets?

Defining EAFE

Arun Kumar, executive director of MSCI Barra, the firm that creates, maintains, and licenses the index, is quick to highlight that EAFE was designed to accurately represent the international market.  “It shouldn’t be judged as a fund,” he explains.  But its wide acceptance as a benchmark to gauge the performance of active foreign fund managers and its ability to be licensed has transformed EAFE into one of the leading international investment vehicles.     

More than 1,000 stocks from twenty-one nations comprise EAFE, ranging from New Zealand’s $128 billion economy to Japan’s $4.4 trillion economy.  Geographically, it reaches from the northwestern-most corner of Europe (Ireland), across the continent to the southeast edges of Asia and Australia.  Business-wise, it’s made up of 68 industry groups crossing 10 sectors.  Average market capitalization of an EAFE holding is $34 billion.

But when you drill into the index’s market-cap weighted composition, a more focused index emerges.  Six countries make up more than three-quarters of the index, led by the UK and Japan, each representing more than 21 percent of the index, followed by France (10.87%), Germany (9.20%), Switzerland (7.46%), and Australia (6.49%). EAFE’s currency exposure is also concentrated, with nearly 80 percent of the index denominated in euros, pound sterling, and yen.  While sector exposure is better balanced with the top five (financials, industrials, consumer discretionary, materials, and consumer staples) representing two-thirds of the index, financials dominate the index, accounting for more than one-quarter of EAFE. 

EAFE’s country weightings are shown in the sidebar, as of June 2, 2008.

EAFE’s weak showing over the past year through August, with the index having lost nearly 14 percent, has pulled down what had been very strong performance across all periods.  Three-year annualized returns were 8.57 percent, five-year gains remained an impressive 14.34 percent, while 10-year gains have moderated to 6.74 percent.

But a good chunk of this performance was generated by the falling dollar, which began declining more than five years ago.  Despite the greenback’s rebound in August, one-year dollar-based EAFE returns were 2.81 percent better than the index measured in local currencies (-13.96% versus -16.77%).  More than 40 percent of the index’s gains over the past three years were due to the weakening dollar; over the trailing five years, more than 31 percent, and over the past decade, nearly 37 percent of dollar-based EAFE returns were attributable to currency.

This doesn’t negate the value of the index. Currency exposure is an inherent quality of unhedged cross-border investing that many investors seek.  But foreign exchange rates never move in just one direction, and investors should be concerned with facing a headwind from less beneficial currency translation going forward.  Utilizing a proven currency overlay manager can help smooth returns, especially when the dollar is strengthening.

Display article as PDF for printing.

Would you like to send this article to a friend?