Long-term investors need international equity exposure. That’s the mantra repeated by the CFA Institute and by advisors everywhere.
A new fund, the iShares Core MSCI EAFE ETF (IEFA) is marketed as an answer to this exact need. It covers developed markets outside of the U.S.
It helps to grasp the broader context on IEFA by holding it up to the largest ETF in the space—its sister fund, the iShares MSCI EAFE Index Fund (EFA). EFA has a massive asset base of almost $37 billion, and its top-tier liquidity means that it's easy and cheap to trade—even for novices.
But for long-term investors, IEFA has two structural advantages over EFA. First, it has a much lower annual fee—0.14 percent vs. EFA’s 0.34 percent.
As a reality check, we at IndexUniverse harp on the fact low fees don’t necessarily mean low all-in costs.
And IEFA will indeed cost more to trade than EFA. IEFA is a brand-new fund still seeking traction with investors, while EFA is one of the most liquid ETFs on the planet.
That said, IEFA’s bid/ask spreads look manageable, so for long-term investors, the lower annual holding cost should more than offset trading costs.
IEFA’s second improvement over EFA is wonkier, but it matters.
Put simply, IEFA does a better job capturing the market. It reaches further down the size spectrum of companies to include small-caps.
That doesn’t mean it’s betting big on small firms. It simply holds them in marketlike proportion, meaning they make up something like 10 percent of the portfolio. In comparison, EFA and many other competing funds lop off these smaller firms.
Index investing means owning the market, with the direct implication that deviations from the market are effectively bets against it.
In this light, EFA bets against international small-caps by ignoring them. IEFA rights this wrong.
The Core Concept
What’s the trade-off? Tradability. Because IEFA holds more small-cap stocks, it’s likely to be harder to trade, even after its shakes off its new-fund status.
This trade-off highlights the iShares “Core” philosophy:IEFA is one of 10 new iShares funds expressly designed for long-term investors who aim for more accurate coverage of the target market and that come with cheaper annual fees. But they’ll cost a bit more to trade.
Still, IEFA isn’t perfect for long-term investors. While it offers deeper coverage than EFA by including smaller firms, it doesn’t improve on the breadth of coverage with respect to country exposure.
Like EFA, it omits all Canadian stocks.
Canada makes up about 10 percent of developed-market equities outside the U.S. and includes major energy, basic materials and financial firms.
IEFA also omits South Korea. The argument is definitional:IEFA and EFA don’t consider South Korea to be a developed market. I’ve heard both sides of this point, but if I have to choose one international equity fund, I want it to hold household names like Samsung and Hyundai.
Returning to the indexing logic above, IEFA and EFA bet against Canada and South Korea.
What Other Alternatives Are There?
You can complement IEFA with single-country ETFs that cover Canada and South Korea, but this solution is cumbersome and expensive.
Single-fund solutions make more sense, but among the dozen or so ETFs that compete, none delivers all the goods over the long haul.
The Schwab International Equity ETF (SCHF) includes Canada and South Korea, but slights small-caps. SCHF is cheap to hold and offers ample liquidity for long-term investors, so the trade-off here is SCHF’s superior breadth on country exposure vs. IEFA’s superior depth on firm size.
The Vanguard MSCI EAFE ETF (VEA) is huge, cheap and liquid, but it currently tracks the same index as EFA, meaning suboptimal depth and breadth. VEA will include South Korea in the first part of 2013, but will still lack small-caps and Canadian equities.
Back To The Future
For long-term investors, I believe IEFA is a better choice than EFA, but please trade with caution in these early days. That means using limit orders rather than market orders. Consulting intraday net asset value (iNAV) might help too, but bear in mind that many underlying securities don’t trade while the ETF itself is trading.
Or wait a bit until the new fund gathers more investor interest.
While IEFA is a solid choice for the long haul, I believe SCHF’s trade-off for country breadth over firm size depth gives it the edge over IEFA and over the present and future versions of Vanguard’s VEA.
At the time this article was written, the author had no positions in the securities mentioned. Contact Paul Britt at firstname.lastname@example.org.
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