Inopportune Exposure and Missed Opportunities

Given the growing maturity and uncorrelated performance of emerging markets, much has been made of late that EAFE is a passé means of going international—that a more ideal index should include these newer economies.  But as we are being reminded today, emerging markets are more volatile and remain linked to developed markets, and that there’s an investment purpose in distinguishing between the two.

There is, however, a more legitimate concern about EAFE’s non-discretionary exposure to various national markets, regardless of past performance.  As mentioned earlier, Japanese stocks have consistently been among the weakest performing shares across the developed market.  They have been in the bottom quintile of the 21 markets tracked over the trailing 3- and 5-, and 10-year periods.

Performance of UK stocks, the largest national market in the index (21.81%), has been only marginally better than Japan over the same time frame.  This means that over 40 percent of the EAFE has been in markets that have been seriously struggling for a long time. 
 
Then there’s the diametric problem of minimal exposure to small markets that have been consistently strong performers and the outright exclusion of a major foreign developed market. Through July, four markets repeatedly appear in the top seven spots in 1-, 3-, 5-, and 10-year time frames:  Singapore, Norway, Denmark, and Canada.  Total exposure of the first three markets makes up only 3.23 percent of EAFE. Canada is not even included.

While past performance does not assure anything, price trends are real.  The increasingly complex metrics that go into formulating more fundamental indices exclude perhaps the most important metric of all: absolute performance.  The existence of price trends argues for tweaking national market weightings according to long-term performance.

While international investors should maintain some exposure to Japan and the UK, it makes sense to pare back EAFE’s weighting until these markets show they can once again generate value. Investors could accomplish this by simply shorting a country-specific fund.  At the same time, enhancing specific country or regional exposure can also be done easily by going long country-specific ETFs. 

Variations on a Theme

MSCI has devised a version of EAFE that equal weights individual stocks, mitigating the differences among countries to more evenly reflect changes in individual share values on the index.  For example, the weight of Singapore and Hong Kong shares, which is just 1.23 and 2.18 percent, respectively, in the market-cap-weighted index is boosted to 3.16 and 4.68 percent in the equal-weighted version.

At the same time, the standing of France and the UK are diminished from 10.84 and 21.64 percent to 7.34 and 12.20 percent, respectively.

But where the equal-weighting approach breaks down in practical terms is with Japan.  Instead of declining, the country’s weight actually soars from 21.34 to 35.96 percent—a change that diminished EAFE’s performance over the last decade.

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