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A common way investors voyage into overseas markets is though a mutual or exchange-traded fund that tracks the MSCI Australasia Far East Index, better known by its acronym, EAFE. This well-established benchmark, which dates back to 1969, tracks approximately 85 percent of the world’s developed markets outside of the Americas. But as this article explores, it may not be the most effective index to gain international exposure.
Market-cap weighted, measuring only stocks’ free float, or the portion of their equity that’s readily tradable (i.e., shares not closely held or government owned), EAFE is the international equivalent of the S&P 500. Like its US counterpart, the index provides heavier exposure to the world’s largest companies, industries, sectors, and national markets. For example, despite the disastrous year commercial banks have had, they still make up nearly 14 percent of the index. And though the Nikkei Index has gone nowhere over the past 15 years, more than one-fifth of EAFE is invested in Japanese stocks.
This exposure and a rallying greenback have contributed to a difficult trailing 12 months, with the index off nearly 14 percent in dollar terms through the beginning of September. That’s about 2.5 percent below the US market. However, EAFE has proven its long-term value. Over the past decade, a period in which the effects of currency translation have been more balanced, the index is up 6.74 percent. That’s over three full percentage points better than the S&P 500.
Asset managers have gravitated to this international benchmark to gain easy-to-obtain, broad, non-discretionary market exposure. More than $50 billion alone is invested in Barclay’s EFA ETF, and Fidelity’s and Vanguard’s open-end fund versions. However, few investors appear to question whether a strictly market-cap weighted approach is the most profitable way to invest. Because it focuses on the largest companies, EAFE emphasizes aggregate past performance and underweights the smaller stocks that have been leading the market. Further inflows into EAFE-tracking funds exaggerate these differences.
Concerns about the shortcomings of market cap weighting have fueled interest in fundamental indexing, which is based on metrics that may better reflect prospective earnings growth than market capitalization alone. For instance, the ETF creator WisdomTree has devised 30 international funds that are weighted by absolute dividends. Its logic: cash dividends provide an objective measure of a company’s value and profitability, and there’s evidence that higher dividend yielding stocks outperform the market. WisdomTree’s EAFE equivalent is the Dividend Index of Europe, Far East, Australia, and Asia, aptly known as DEFA. Its performance topped the EAFE benchmark over the trailing 1-, 3-, 5- and 10-year periods through August.
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