Digging into the EAFE Index: Lessons for International Investing

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 |  Includes: EFA, SPY
by: Don Dion

The main benchmark index for international investing is the MSCI EAFE (NYSEARCA:EFA), which stands for Morgan Stanley Composite Index Europe, Australasia, and Far East Index. This index “aims to capture 85% of the (publicly available) total market capitalization” (Source: MSCIBarra.com); hence it is a capitalization-weighted index like the S&P 500. Japan and the U.K. constitute about 25% and 20%, respectively, of the index; Australia, Germany, Switzerland, and France each compose more than 5% of the index.

Any broad global or international fund will be weighted heavily toward markets with greater total capitalization, whether or not they use the EAFE as a benchmark. Developed nations’ stock markets are generally larger relative to their GDPs (even for small countries), while large developing economies can have relatively small stock markets. In 2006, for instance, Canada’s total stock market capitalization was double that of China’s even though China’s GDP was two-and-a-half times the size of Canada’s. Following China’s stock market boom, the situation has been reversed: China’s stock market is twice as large as Canada’s. The implication is that if you want to invest in a developing economy, your best bet is to select a fund that targets that market. If the fund does not specifically target that region or country, investigate the fund’s holdings to see if it offers the exposure you’re looking for.

The EAFE index has beaten the S&P 500 (NYSEARCA:SPY) for most of its existence. Starting in the late 1970s and accelerating into the early 1990s, the EAFE is far ahead of the S&P 500. However, in local currency, the EAFE did not seriously outperform the S&P 500 except from the early 1980s through the early 1990s and to this day lags behind the S&P 500. This means that the outperformance of the EAFE has been partly due to the relative weakening of the U.S. dollar. In 1985, the G5 nations signed the Plaza Accord, in which all five nations (the U.K., France, West Germany, Japan, and the U.S.) agreed to weaken the U.S. dollar. The dollar subsequently fell by more than 50% versus the yen over the course of two years, while the Nikkei 225, an index of Japanese stocks, soared to new heights and pulled the EAFE with it. In the early 2000s, the EAFE in local currency outperformed again and closed the gap with the S&P 500 index, but the rising dollar in late 2008 hurt the returns on the EAFE in dollar terms. From the end of June 2008, the MSCI EAFE lost 49.2%, the MSCI EAFE local currency lost 39.5%, and the S&P 500 index lost 43.8%.

The bull market ended in 1989, when the Nikkei peaked and began a long bear market that has yet to end. In contrast, during the 1990s, the U.S. dollar bottomed and the S&P 500 began a record bull run, leading it to outperform the EAFE by a wide margin. By 2002, the S&P 500 and the EAFE had been roughly even since 1970. Part of the large over- and then underperformance of the EAFE was caused by Japan’s influence in the index, and that begs the question: What would happen if Japan were removed from the index?

The EAFE has tracked very closely to the S&P 500 when Japan was removed from the index. This may be surprising, but Japan was a special case among the nations in the EAFE. The developed countries all grew at similar rates, but Japan went from a relatively underdeveloped nation to the world’s wealthiest by the end of the 1980s, when it accounted for half of the EAFE. (Hong Kong, Singapore, and Ireland all had similar growth trajectories, but they make up a far smaller component of the index.) Japan then experienced a long period of stagnation that the rest of the world avoided.

Another interesting fact is that as late as 2002, and again during 2008, the EAFE without Japan in both dollar terms and local currency was roughly the same. This means currency fluctuations averaged out to provide no advantage or disadvantage over the past 30-plus years when Japan was excluded. Nevertheless, an investor with a relatively long holding period of five years would have seen his or her investment significantly affected by currency fluctuations. Since 2002, for instance, the EAFE quoted in dollars has soared past the EAFE in local currency as the dollar declined versus the EAFE currencies, and in the past year those gains have collapsed.

In sum, a large portion of the performance of the EAFE over the past 30 years can be attributed to two major factors: the strengthening yen and the movement of the Japanese stock market. Given the weight of Japan in the index, this makes perfect sense. It is a good lesson to remember and an inherent risk of market capitalization–weighted indexes: a small number of components compose a large portion of the returns. Within the EAFE today, Japan and the U.K. account for half the index, but many national indexes suffer the same risk, with just a handful of large companies accounting for most of the total market capitalization. Currency did not play a large factor in returns over extremely long periods of time, but in periods stretching as long as a decade, it did. The recent frenzy over international markets had as much to do with rising equity prices as with the falling dollar. Whether or not that trend continues will have a significant effect on relative returns over the next five to ten years.