Following a meltdown in the U.S. financial markets that sparked a global recession, many investors have begun to question traditional asset allocation strategies that call for a significant weighting to American stocks. While emerging markets have seen huge cash inflows as a result of this trend, developed markets beyond North America have also benefited. For investors looking to spread their developed markets exposure beyond the U.S., EAFE index funds and ETFs are one of the most popular options. And while the majority of assets in this region are concentrated in a single fund, the options for EAFE exposure are numerous.
Under the Hood of the EAFE
EAFE stands for Europe, Australasia, and the Far East, but is widely understood to include the world’s developed markets outside of North America. Although the elimination of trade barriers and greater coordination among industrialized economies has increased the correlation between advanced economies, this relationship is far from perfect. The contrast between the ongoing economic woes of Japan and relatively quick turnaround in Australia is evidence of these differences, highlighting the importance of diversification within the developed market portion of a portfolio. ETFdb Pro members can see the allocations given to the EAFE region in our all-ETF model portfolios (if you’re not a Pro member yet, sign up for a free trial or read more here).
The MSCI EAFE Index is a benchmark measuring the performance of stock markets in these regions, offering exposure to nearly two dozen countries (Japan, the United Kingdom, and France receive the largest allocations) that is spread across all sectors of these economies. The most popular option for gaining exposure to this basket of developed economies is the iShares MSCI EAFE Index Fund (EFA), which has a market capitalization of more than $35 billion and an average daily volume of nearly 20 million shares.
But for investors considering exposure to the EAFE region, EFA is just the beginning. Below, we profile five alternative options for adding the EAFE to client portfolios (for more in-depth looks at ETF options, sign up for our free ETF newsletter).
- iShares MSCI EAFE Value (EFV) and Growth (EFG) Index Funds: Just as funds focusing on different strategies are available for domestic securities, EFV and EFG offer an option to limit exposure to either value or growth companies. A word of caution though: the overlap between these ETFs is significant. As of November 30, 2009, approximately 25% of the value fund components were also held by EFG.
- iShares MSCI EAFE Small Cap Index Fund (SCZ): Whereas EFA is dominated by holdings in mega-cap stocks (HSBC, BP, Nestle, Banco Santander, and Total SA comprise the five largest holdings), SCZ invests in small cap companies in the EAFE region. SCZ tracks an index that targets 40% of the eligible small cap universe in each industry group of each country represented by the EAFE Index. While the country and sector allocations between EFA and SCZ are similar, these funds have unique risk and return profiles: EFA was up 27% in 2009 while SCZ added nearly 43%.
- WisdomTree DEFA Fund (DWM): This ETF is a dividend-weighted fund that is designed to track the performance of companies in the industrial world (excluding Canada and the U.S.) that pay regular cash dividends. DWM gained about 27% in 2009, approximately the same return delivered by EFA. DWM operates as a “fund of funds,” investing in other WisdomTree ETFs to achieve its objective.
- WisdomTree DEFA Equity Income Fund (DTH): This fund tracks the performance of companies with high dividend yields selected from the WisdomTree DEFA Index (the benchmark to which DWM is linked). To determine holdings, components of the WisdomTree DEFA Index are ranked by dividend yield, with the highest 30% being selected for inclusion. As of January 4, DTH had a dividend yield of 5.3%, significantly higher than the current return on EFA.
- WisdomTree International Hedged Equity Fund (HEDJ): WisdomTree’s most recent fund launch is also a twist on DWM. This ETF offers EAFE exposure that is hedged against fluctuations in the relative value of non-U.S. currencies against the U.S. dollar (to read more about how HEDJ works, see this feature). Unhedged investors in EFA are exposed to a variety of currency risks, essentially meaning that they are exposed to the possibility of diminished bottom line returns if the dollar appreciates, and higher returns if the dollar loses value to major rivals.
Disclosure: No positions at time of writing.