Managers who closely track market-cap-weighted
country indexes may miss opportunities.
With burgeoning foreign equity markets and a soft
dollar, things have been sweet for U.S.-based international investors.
In 2006, MSCI's EAFE Index-the key global equity benchmark that tracks
developed markets across Europe, Australia and Asia-appreciated nearly
27% in U.S. dollar terms. Three-year annualized returns topped 20%.
Five-year annualized returns were 15.43%. And even ten-year returns of
8.06% remind investors that foreign stocks do perform well over the
long run.
With returns like these, most advisors would
probably be satisfied sticking with this tried and true method of
gaining foreign exposure. Barclay's Global Investors' EAFE iShares, for
instance, offers an ETF without any sales fee, and its annual expense
is a mere 35 basis points.
But if you scratch just below the surface of this widely embraced
global benchmark, you can find weak spots that leave room for
improvement. Like most market indices, EAFE weights constituent
countries by their respective market capitalizations. That means five
countries-the United Kingdom, Japan, France, Germany and
Switzerland-comprise 70% of the index. This makes EAFE look like a
concentrated country play rather than a balanced global investment.
Despite these concentrations some observers, like
Princeton economics professor Burton Malkiel, believe outperforming
market-cap-weighted indices is a pretty difficult thing to do. The
majority of active managers underperform their benchmarks because of
two basic reasons. "First," Malkiel explains, "they charge higher
annual expenses than index funds because of greater research, trading
and marketing costs. Second, deviating from the index involve elements
of stock, sector and/or style picking. To do so correctly over an
extended period of time becomes a matter of virtual genius, which is
rare to find."
Linking purchases to market capitalization certainly
addresses the matter of liquidity. But since most advisors' decisions
don't move markets, there doesn't appear to be any inherent reason to
base country weights solely on market size.
In fact, doing so would seem to emphasize past
performance at the possible expense of future appreciation. And Robert
Arnott, chairman of the Pasadena, Calif.-based investment advisory
Research Affiliates, believes that the explosion in asset-weighted
investment vehicles has contributed to overvaluation of the largest
index components due simply to a "piling on" effect, which compromises
performance.
Look at Japan's market capitalization, which
represents more than 22% of EAFE. The country's sluggish economy
continues to fight its way out of difficulties since the real estate
bust of the 1990s, and performance of the stock market remains erratic.
In 2006, Japanese stocks rose only 6.33% in dollar
terms-the worst developed market performer. Five-year annualized
returns are a bit better at 13.65% [still among the lowest of all
developed markets]. But ten-year annualized returns were just
2.30%-again, coming in at the bottom of the list. Despite this
protracted market malaise, EAFE investors are still allocating nearly a
quarter of every dollar into this market.
On the other side, the Viennese bourse represents just 0.60% of EAFE.
Its market cap of 138.6 billion is about half the size of Microsoft.
However, with European Union expansion into central and Eastern Europe,
and given Austria's historical and cultural links to these markets,
Austrian firms are playing an integral role in the region's rapid
expansion through acquisitions and organic growth. The result: Austrian
stocks have been booming.
Over the past one, three and five years, Austrian
shares have averaged annualized growth of 40% in U.S. dollar terms. And
their ten-year annualized return is among the best across the developed
markets, averaging 15.75%. But given its miniscule market cap, few
international managers have materially benefited from the country's
tremendous performance.
But some did. Michael Sieghart, who runs the 712
million DWS Invest European Equities Funds, had nearly 15% of his
portfolio in Austrian shares in 2006-more than 15 times the MSCI
Europe's benchmark weighting of 0.8 %. This exposure helped generate
three-year annualized returns of 22.5%, outpacing MSCI Europe Growth
Index by 6.4% a year.
Last year his biggest holding was in Austria's
largest life insurer, Wiener Städtische Versicherung. Having
represented nearly 4% of his portfolio, the Vienna-based insurer has
been feeding off the region's low but rising penetration of life
products. Central and eastern Europe now generate 30% of the firm's
premiums, up from zero just five years ago. This has significantly
boosted annual revenue by 12% to 15%, pushing earnings up an
average of 22% over each of the past three years. And Sieghart expects
more upside, given the region's fragmented insurance market and
convergence of local insurance demands with those of Western Europe.
"While ultimately a matter of stock picking,
successful country overweighting requires vigilance," explains
Sieghart, "knowing when to pull back on market exposure as well as when
to increase it." In 2006, as valuations grew rich, and ahead of
projected growth rates, Sieghart pared back his Austrian weighting by
half.
Another manager who successfully bucks EAFE is Paul
Casson. He runs the $459 million Ivy European Opportunities fund, which
has generated five-year annualized returns of 24.76% through January
19, 2007, besting MSCI Europe by 8.91% a year. One key reason has been
Casson's 9.5% exposure to Spain, more than 60% higher the benchmark's
allocation.
Last year the Madrid borsa was the top-performing
developed market, climbing by more than 50% in dollar terms. Five-year
annualized returns were 22.55% and ten-year returns averaged more than
15%, among the best around.
The Iberian market has been a good bet for unique
systemic reasons. Throughout the 1990s, propelled by efforts to qualify
for common currency, Spain embraced privatization and competitive
market reforms. Ascendance into the euro was a boon for corporate Spain
through interest rate convergence from perennially double-digit to low
single-digit interest rates. And euro membership eliminated currency
volatility, which had long been the bane of the peso.
As a result, Spain has been among the continent's
fastest growing markets. This has led to a wave of corporate
acquisitions across Latin America. And more recently, many of the
country's biggest firms, including incumbent telecom service provider
Téléfonica, the country's largest banking groups, Santander and BBVA,
and Spain's largest infrastructure developer, Ferrovial, are branching
out across Europe's developed and emerging markets, providing further
octane to Casson's portfolio.
Another well-diversified country that perennially
outperforms EAFE in both local currency and dollar terms but with low
benchmark weights is Ireland, which represents only 0.85 % of EAFE. Its
market soared by nearly 48% in dollar terms last year, topping the
index by more than 20%. The country's five- and ten-year annualized
returns of 17.01% and 9.81% outperformed the benchmark by 158 and 175
basis points respectively.
Swedish stocks jumped 44.64% last year, and their
long-term numbers were even better than Ireland's, besting EAFE by 712
and 725 basis points annually over the past five and ten years. Its
index weighting is just 2.58%.
And despite being an entire continent blessed with
phenomenal resources and proven service industries strategically
positioned in the hypergrowing Far East, Australia's market cap
represents only 5.55% of EAFE. In 2006, Aussie's shares rose 32.51%.
And over the past five and ten years, the market outpaced EAFE annually
by 998 and 472 basis points, respectively.
The belief that international asset managers can
improve country weighting (without cherry picking markets) is receiving
support from a growing community of advisors who are coming to the same
conclusion, albeit through different tacks.
Wharton School professor of finance Jeremy Siegel
has recast major indices based on absolute dividends paid [not yield).
Back-testing this strategy from 1996 through 2005, his DIEFA portfolio
[Dividend Index of Europe, Far East and AustraliaAsia] outperformed
EAFE by 544 basis points per year. Siegel's strategy is enhancing
country performance, with his U.K. equities outperforming their
market-cap-weighted benchmark by 332 basis points and his Germany
shares outpacing their respective index by 267 basis points.
But his portfolio gets a second boost from more productive country
weightings. For example, Japanese equity weighting drops from 22.30% to
8.33% and Australian representation increases from 5.55% to 8.13%.
In addition to dividends, Rob Arnott adds revenues,
cash flow and book value in devising his fundamentally weighted
indices. "Relying on just dividends leaves out too much of the market
and ends up producing portfolios that are heavily tilted to financials
and utilities," observes Arnott. Back-testing his international
portfolio 22 years resulted in annualized country outperformance of 250
basis points, with an additional 100 basis points of alpha derived from
improved country weighting.
Most impressive, Arnott found that during this
period, the index never underperformed EAFE for any five-year rolling
period. Two key reasons: Arnott's weighting process reduces the impact
of overvalued stocks while boosting the contribution of lower valued
shares, and annual rebalancing prevents shares from receiving excessive
or reduced weighting when their prices shift without a change in their
fundamentals.
So should advisors try to reweight benchmarks?
"Never think you know more than the markets,"
exclaims the founder of the Vanguard Group John Bogle. "Nobody does."
It's hard to argue with a legend, who has brought such benefits to
individual investors through his ultralow-cost index funds. But it's
also against man's nature not to push the envelope. And that's the way
new investment ideas do indeed evolve.