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By Alex Bryan

Value stocks outperform in the long run. Why then would anyone want to invest in a growth fund? Although high-growth stocks often represent speculative companies with limited earnings history, a broad-growth fund typically offers a portfolio of high-quality companies that can weather bad times better than their peers. Growth stocks generally trade at higher multiples, so paying too much for quality can wipe out the benefits. But when the valuation gap between value and growth stocks is reasonable, as it is now in the MSCI EAFE Index, this quality tilt can offer defensive market exposure.

Uncertainty abroad may deter investors from leaving the comfort of the United States market. However, global diversification is as important as ever. iShares MSCI EAFE Growth Index ETF (NYSEARCA:EFG) invests in companies with the strongest prospects for growth from the MSCI EAFE Index, which includes large- and mid-cap companies based in developed markets in Europe, Asia, and Australia. Because the MSCI EAFE Growth Index covers approximately half of the assets in the MSCI EAFE Index, it does not overweight cutting-edge, high-risk, high-return growth stocks. Rather, its portfolio skews toward high-quality names, such as Diageo (NYSE:DEO), Toyota (NYSE:TM), Nestle (OTCPK:NSRGY), and Roche (OTCQX:RHHBY). EFG is a suitable core holding for investors who have heavy exposure to U.S. and Canada and want to build a global portfolio with a quality tilt.

It is no accident that EFG has given investors a smoother ride than both iShares MSCI EAFE Index (NYSEARCA:EFA) and iShares MSCI EAFE Value Index (NYSEARCA:EFV) since its inception in 2005. Despite its richer valuation, EFG's portfolio of quality companies was better positioned to weather the global financial crisis in 2008 and the subsequent European sovereign debt crisis. EFG's holdings have lower debt/capital ratios, higher returns on invested capital, and better profit margins than the broader MSCI EAFE index. Consequently, EFG may offer a more defensive way to gain access to the developed markets in the EAFE Index. However, in the long term, value stocks tend to outperform both growth stocks and the broader market in most countries. Therefore, investors looking for long-term exposure to foreign equities--and who are willing to bear a little extra volatility--might be better off in a broad market or value fund.

Relative to the MSCI EAFE Index, EFG has greater exposure to consumer defensive and industrial stocks and significantly less exposure to the financial services sector. Because MSCI anchors the growth index's country weights to the MSCI EAFE, it offers similar country exposure. While nearly two thirds of EFG's portfolio is held in European stocks, it has limited exposure to the weakest members of the eurozone.

Fundamental View
Sovereign credit risk and weak demand resulting from high unemployment and austerity measures will continue to weigh on the fund's European holdings. These risk factors have depressed the prices of European stocks across the board. The fund has been trading at a discount to its average P/E ratio since inception. As of this writing, the valuation gap between value and growth stocks in the MSCI EAFE Index was in line with its historic average.

The fund’s large European stake exposes it to deteriorating sovereign credit quality. In September, the European Central Bank announced that it would make unlimited purchases of sovereign bonds from troubled euro countries that applied for aid in an effort to keep their borrowing costs low. While this program allayed the possibility of an immediate default, it does little to resolve the risk of a long-term recession as governments and banks deleverage. In order to receive aid, countries that apply likely will need to implement austerity measures that could push them further into recession. Therefore, despite the ECB's program, Standard & Poor's recently downgraded Spain's government debt to its lowest investment-grade rating and placed a negative outlook on the country's credit due to uncertainty about its willingness and capacity to implement unpopular budget reforms.

EFG's 28% stake in developed Pacific markets consists mostly of Japanese companies, followed by Australian companies, which tend to have a cyclical tilt. Growth in Japan has been sluggish during the past two decades because of structural problems that continue to create a challenging operating environment. For instance, Japan faces a thrifty and rapidly aging population and a strong yen, which makes Japanese exports less competitive. However, valuations for Japanese equities are very cheap. Over the longer term, Japanese companies may benefit from emerging-markets demand for their capital equipment, consumer products, and electronic goods.

The health of the Australian economy is tied to the mining and basic materials sectors. China accounts for nearly 40% of global demand for base metals. Consequently, slowing growth and fewer infrastructure investments in China are creating headwinds for many of the fund's miners, including Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP). Fiscal tightening and a strong Australian dollar, which makes the country's mining exports less competitive, create additional near-term headwinds.

During the past few years ,EFG's returns have been boosted by the appreciation of the euro and yen. However, Japan and the eurozone have pursued aggressive monetary policies and face rising entitlements and debt levels, which likely will weigh on each region's respective currency in the longer term. Because the fund is denominated in U.S. dollars, this could cause it to lose value, even if its holdings rally.

Portfolio Construction
EFG uses full replication to track the MSCI EAFE Growth Index. This benchmark includes approximately 50% of the assets in the MSCI EAFE Index (which provides exposure to 22 developed countries in Europe, Asia, and Australia) with the strongest prospects for growth. MSCI uses an eight-factor model to classify a stock as value or growth, three for value and five for growth. The growth factors include long- and short-term forward earnings per share growth, historical EPS growth, sales growth, and internal growth. When a stock exhibits a dominant style, MSCI fully allocates it to either the value or growth index. Of course, it is possible for a stock to have both characteristics, or neither. MSCI partially allocates these stocks to both the value and growth indexes so that 100% of the assets in the MSCI EAFE Index are represented in either the MSCI EAFE Value or MSCI EAFE Growth Index. Therefore, it is possible for the same stock to appear in both. MSCI applies buffer rules to limit movement between the value and growth categories. The index anchors its country weights so its geographic exposure is similar to that of the MSCI EAFE Index. Relative to this index, EFG overweights consumer defensive (22%) and industrial stocks (18%).

Fees
The fund levies a 0.40% expense ratio, which is comparable to other international strategy funds. BlackRock (NYSE:BLK) engages in securities lending, the practice of lending out the underlying shares in exchange for a fee. It passes through 65% of the proceeds to investors, which partially offsets the fund's trading costs.

Alternatives
As of this writing, EFG is the only fund that offers broad international growth exposure. However, iShares MSCI EAFE Minimum Volatility (NYSEARCA:EFAV) may be a suitable alternative. This fund attempts to create the lowest-volatility portfolio out of EAFE stocks while keeping sector and country weightings within 5% of the MSCI EAFE Index. Low volatility companies also tend to be the most resilient during market downturns and tend to be stable, high-quality businesses. Nearly 59% of EFAV's portfolio overlaps with EFG. EFAV charges a 0.20% expense ratio, which is low for an international strategy fund.

Because value stocks tend to outperform over long investment horizons, long-term investors could capture a higher expected return in iShares MSCI EAFE Value Index (0.40% expense ratio) or iShares MSCI EAFE Index (0.34%), which includes both value and growth stocks. However, both of these funds are slightly more volatile than EFG.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: The Value In International Growth