This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by David Allen, a portfolio manager at Walnut Creek, California-based Accuvest Global Advisors.
As part of my work in the advisory and brokerage space, I get a chance to meet with teams from all around the country, with all different types of practices.
One of the more common comments I hear from advisors/teams in the U.S. is that they feel they have a good methodology for investing in domestic securities, but when it comes to international investments, they “just use the EAFE [index].”
The reason most advisors take this route has to do with the simplicity and the belief that they are buying a single product that will give them diversified exposure to the international markets.
Unfortunately, what the majority of investors don’t realize is that roughly 80% of the index is in the top six countries, and there is no exposure to emerging markets.
My suggestion for them is to take the time to assess those top six countries, and then invest in the ETFs of the ones they actually want to be invested in. Those countries can be easily paired with an emerging market ETF to round out the international part of the portfolio. The end result will be a more thoughtful exposure that clients will actually understand better.
Meaningful Performance Differentials
The biggest drawback to buying an indexed product based on EAFE is that you mix the winners with the losers, and wind up with a return somewhere in the middle.
Because this index has so much concentration toward the top, the thought of getting a diversified basket of 21 countries does not hold the same merit. During 2015 alone, there has been a 40% performance differential between the best-performing country (Denmark, +18.8%) and the worst (Singapore, -21.1%).
What is even more frustrating for investors is that, while the index is down -1.9% for the year, several countries have had positive double-digit returns (Denmark, Belgium and Ireland). The problem with concentration is that those three countries make up less than 4% of the index.
Put a different way, an EAFE investor currently has 14x more exposure to the three biggest constituents than the three-best-performing constituents.
Promising Countries Going Into 2016
When it comes to taking overweights and underweights versus an index, our recommendation is to start with the biggest names.
If you can make an informed decision about those names, investors will give themselves the best opportunity for improved performance while taking calculated risks. Our assessment of countries comes down to which ones offer the best combination of fundamentals, momentum, risk and value characteristics.
In breaking down the EAFE’s top size constituents, Japan and Germany stick out as key overweights, while France and Australia are two that we think should be avoided.
Japan is the largest weight in the EAFE index, at 23%, and should remain an overweight heading into 2016. Japan has very low risk compared with the rest of the world, and is on track for steady growth.
The biggest consideration to make about Japan is how to play the currency. Hedging the yen in 2015 has given investors around an extra 5% of performance. We currently use the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-84) for our exposure.
France is a 10% weight in the EAFE, and a country we feel should be underweighted. Momentum has been strong, but investors have only realized that if they hedged the euro. France is up 18.4% in euros, but only 3.3% in U.S. dollars. This price appreciation has now impacted the valuation factors where France is currently one of the most expensive countries in the world.
Germany is a 9% weight in the EAFE and should remain an overweight. The country has been one of the best places to invest in over the last three months, up more than 10% in local currency.
While Germany faces the same currency issues as the rest of the euro-based countries, the growth prospects in the country are significantly better than the rest of Europe. The weakening euro should continue to help its global competitiveness, but should be hedged for dollar-based investors. Our current exposure to Germany is the Deutsche X-trackers MSCI Germany Hedged Equity ETF (DBGR | B-63).
Australia is a 7% weight in the EAFE, and should be underweighted. Slow internal growth rates and negative leading economic indicators paint a bleak picture for the country. The hit to the commodity sector has been difficult on Australia, and there is no immediate sign of recovery. Australia is down 12.6% this year, with more than 10% of that coming from the depreciation of the currency relative to the U.S. dollar.
3 Questions To Ask About Your Global Exposure
The biggest takeaway that I communicate to advisors who use the EAFE as their international exposure usually comes down to answering three basic questions: 1) Do they know what they are investing in? 2) Do they want to invest in those countries? 3) Can they now build a more thoughtful portfolio?
Accuvest Global Advisors (AGA) is a registered investment advisor based in the San Francisco Bay Area. Founded in 2005, AGA has drawn considerable recognition in the industry for its work in building global strategies through the use of single-country ETFs. For more thought leadership and firm updates, visit www.accuvestblog.com, www.twitter.com/Accuvest or email firstname.lastname@example.org.
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