Although there is little doubt that in 10 years' time U.S. equity prices will be higher than they are now, buying the index to hold at all-time highs rarely maximizes the investors return. Of course, as a recent Seeking Alpha article pointed out, the stock market is a giant auction house, therefore if you have the time you could simply find the best deals in U.S. equities, monitor them, and maximize your return on investment that way, but few retail investors have the time to do so.
In addition, many retail investors who deal with investment advisors own the index without knowing that they do. This is due to excessive diversification, demonstrated by the chart below.
The chart above is from the course I took at the National University of Singapore under Dr. Jiekun Huang titled Investment Analysis and Portfolio Management, while completing my undergraduate degree. The term "idiosyncratic risk" can be thought of as company specific risk (defined by variability of returns), whereas "systematic risk" can be thought of as market risk, or the risk you'd take on owning the index. The takeaway from this chart is that if your portfolio is long 15 or more stocks, especially larger-cap stocks, which is primarily what investment advisors will purchase, your investment advisor is nothing more than a coach. You could save all the fees, buy the index, and accomplish better returns due to the savings of the fees.
Of course, this would mean no pats on the back or high fives, but there is no utopia, only trade-offs.
I recall looking at my late grandpa's portfolio and realizing that his investment advisor was providing little value other than acting as a "financial coach," preventing him from selling at the bottom. There is value in having a coach like this, just as there is value in hiring a personal trainer to get fit, but you don't need a personal trainer to get fit, and you don't need an investment advisor to build wealth.
Owning European versus U.S. Equities
This brings me to the crux of this article. If your portfolio consists of being long 15 or more large-cap stocks and you are paying an investment advisor 1%, you may want to ask yourself how much a financial coach is worth to you. If you're a retail investor who doesn't want to continuously monitor your stock picks but wants to build wealth, index ETFs are for you.
Of these ETFs, one of my favorites is the Euro Stoxx 50 ETF (FEZ). It is made up of the largest companies across Europe, yields over 3.5% and is trading well below 2008 highs of over $60 at $35 per share:
The best way to demonstrate the value of this ETF is to compare it to its counterpart in the U.S., the Russell Top 50 ETF (XLG).
XLG is an ETF comprised of the largest 50 stocks in the U.S. by market capitalization. It is particularly comparable to the European Union as the U.S. is approximately the same size economically as the EU with 2012 GDPs of $16,566 billion and $15,094 billion respectively.
I've compiled a head to head matchup below highlighting the most important metrics.
Source: ETF Database
The expense ratio is marginally higher in the FEZ than the XLG, but not enough to be relevant. Interestingly, the hot money as of late has been flowing into Europe, although year to date (YTD) large-cap U.S. equities have performed much better. Last but not least, the dividend yield of FEZ is double that of XLG, my favorite outperformance metric.
I've charted the comparative performance below over three time frames, the blue is the XLG and the red is FEZ.
The top 10 holdings of each ETF are below.
Source: ETF Database
The numbers of stocks contained in each ETF are the same, and interestingly enough, the assets in the top 10 are as well. This indicates that the distribution of the size of the largest market cap stocks in the U.S. and EU is relatively similar. In regards to the companies, the differences seem to be culturally based, with many oil companies in the top 10 in the XLG, and a beer company in the FEZ.
This divergence in the types of companies can be further seen in the sector breakdown of the companies in each ETF.
Source: ETF Database
As I've stated before with regards to the FEZ, some may see the concentration in financial services as a minus, I see it as a plus, especially in Europe. With all the financial turmoil still taking place there, the banks there are trading at historic lows, thus a diversified portfolio of financial service companies will likely do well over the longer term. American ingenuity is quantified by the most successful companies on each side of the Atlantic, as technology stocks make up only 3.65% of the FEZ, whereas they make up 22.50% of the XLG. This is in large part due to Apple (AAPL), but thus far in my experience of visiting both places, I would say it is culturally accurate to depict Americans as more risk seeking, which would lead to more technological breakthroughs, and therefore more technological companies in the top 50.
The breakdown of market cap and country allocation is below.
Source: ETF Database
The companies in the U.S. are larger, which should be of little surprise, and may also speak to the lower valuations in Europe at the moment.
With regards to country breakdown, France and Spain make up almost half of the index, which is a factor to keep an eye on, but don't lose sight of the fact that the companies in France and Spain are not the governments of France and Spain. These are global companies with global operations that will be generating cashflows whether the euro survives or not, whether the ECB cuts rates or not or whether France or Spain or Portugal or Cyprus defaults.
The most compelling reason for owning FEZ is from a valuation perspective. Below is the breakdown of key value metrics of the FEZ versus the XLG.
Source: State Street Global Advisors and Guggenheim Investments
From a value perspective, the companies in the FEZ are half the price of the companies in XLG. This is understandable given the far superior return on equity of the companies in XLG, but return on equity is a backward-looking metric. There is little room for improvement in the return on equity in XLG, whereas there is plenty of room for improvement in FEZ. When FEZ's companies return on equity catches up to their counterparts in the XLG, the Price/Book ratio and the P/E ratio will also catch up, leading to significant price appreciation of FEZ.
The Bottom Line
I could bloviate on about how great of an investment FEZ is, but one sentence will suffice. It is the largest holding in my Mom's portfolio.