Excerpted from Michael Krause's ETF Advisor for April: As well as U.S. markets have performed over the past few years, many foreign markets have done notably better. The iShares MSCI EAFE fund (EFA), which tracks an index of developed-economy stocks widely considered to be the international counterpart for the S&P500, has outperformed handily since 2003, gaining 169% vs. 84% for the S&P500 SPDR (SPY). Meanwhile stocks in the iShares MSCI Emerging Markets fund (EEM) have done even better (Figure 1), leaving many investors wondering if it isn’t time to bring some money home.
Regular readers will know that we still like many emerging markets (EEM as well as some other single country funds) despite their outsized gains, while we think EFA seems fully valued if not slightly expensive versus the S&P 500. Unfortunately, this presents a conundrum for conservative investors who still want international exposure but are looking for more value than they can find in EFA and who’d rather not stomach the volatility of emerging markets.
We think a good option for such investors is the PowerShares International Dividend Achievers index fund (PID). While not the highest yielding fund (at 2.9%) you can find among international ETFs, PID provides diversified, international exposure with the safety of consistent dividends, below-average volatility—and slightly better valuations.
PID tracks the International Dividend Achievers index, published by financial information firm Mergent. Criteria for inclusion in the index, which currently consists of 81 stocks, are that a foreign company must have a U.S. listing (i.e., ADR) and have a history of increasing annual dividends every year for at least the past five years. Stocks are weighted by yield and the index is rebalanced quarterly.
Like the MSCI EAFE fund, PID has heavy exposure to Financials (Figure 2), but in terms of country exposure the two differ markedly. Although both have roughly a quarter of assets invested in U.K. companies, PID has considerable exposure to Canada whereas EFA has virtually none. Meanwhile EFA is heavily invested in Japan while PID’s exposure is limited (23% vs. 3%). Lastly, PID offers some exposure to emerging markets (about 9%) while EFA has none (that’s not a criticism; EFA isn’t designed to have emerging markets exposure).
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Although PID has limited trading history (it was listed September 15, 2005), both the International Dividend Achievers index and the MSCI EAFE index have lengthy published histories to compare. A prior study we did examining ten years of index returns through June 30, 2005 showed the Dividend Achievers index strategy produced a total annualized return of 10.6%, compared with 5.6% for the MSCI EAFE index (Figure 3).
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Hypothetical results from past performance are all fine and good, but of course what we’re really concerned with is future performance, and that is where fundamentals come in. Both EFA and PID are cheaper than the S&P 500 in terms of the price-to-earnings ratio, PID a bit more so (Figure 4). But one of our criticisms of EFA has been that this valuation discount versus the S&P 500 is deserved, because companies in the index—especially the Japanese firms which account for about 1/4th the fund—are consistently less profitable than their U.S. counterparts.
Firms in EFA achieve an average Return on Equity of 14.3%, compared with 17.4% for the S&P 500. In contrast, firms in PID achieve an average Return on Equity of 17.2%, on par with that of U.S. firms. Correspondingly, EFA trades at a lower price-to-book value (P/BV) multiple than the other two indices.
However, calculations in Table 1 below imply that, combined with fund fees, firms in EFA are still somewhat expensive relative to their sustainable earnings power (average ROE), and therefore could deliver sub-par returns going forward, as indicated by the lower ALTAR™ score. In fact, what keeps PID from standing head-and-shoulders above the others are its relatively high expenses. If the expense ratio were the same as that for SPY, the fund would have an ALTAR™ score of 6.9%. But alas, fees are a fact of life and reduce the return on your investment, so must be taken into account.
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Finally, for what it’s worth, PID has been less volatile than EFA and also slightly less correlated to the S&P500 during its limited trading history. Combined with PID’s higher expected return, if these figures have any validity than one could both increase returns and lower risk in a portfolio by swapping out of EFA in favor of PID. That sounds like a move that would make any conservative investor happy.
