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.