The so-so performance of the EAFE Index stems from its regional allocations and focus on large-caps.
By Daniel Sotiroff | 08-11-17 | 06:00 AM | Email Article

The proliferation of index funds has been a tremendous benefit to individual investors. Low-cost access to a representative, well-diversified portfolio has enabled them to piggy-back on the collective efforts of active investors.

Daniel Sotiroff is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

But the assumption that these characteristics cause index funds to outperform a majority of active managers has been weaker for those that track the MSCI EAFE Index. For decades this index has been referenced by investors and fund managers alike as a representative benchmark for foreign stocks. But the performance of this stalwart index relative to funds in the foreign large-blend Morningstar Category has been tepid to say the least.

Its annualized returns, on both an absolute and risk-adjusted basis, have fluctuated around the category midpoint. The S&P 500, a comparable U.S. large-cap index, has generated returns that have ranked high against U.S. large-blend funds. The composition of the MSCI EAFE Index provides some insight as to why it has been such a mediocre benchmark.

Index and category compositions aren’t static, so it makes sense to observe how the S&P 500 and MSCI EAFE Index have ranked within their respective categories over time. Exhibit 1 shows the category rankings for the MSCI EAFE Index and S&P 500 during each rolling 36-month period.

The category-relative performance of the S&P 500 was fairly strong. On average, the category rank of its three-year returns fluctuated around the 70th percentile during this 30-year period. The strong category-relative performance of the S&P 500 continues to support the idea that a low-cost fund that simply tracks this index is a reasonable passive investment vehicle for U.S. stocks.

However, the category-relative performance of the MSCI EAFE Index was less than stellar, as it fluctuated about the 50th percentile. There are two major insights regarding the regional make-up of this index that speak to its lackluster category-relative performance.

To start with, the diversification of the MSCI EAFE Index was compromised in the late 1980s, with 60% of its portfolio dedicated to Japanese stocks following their strong rally in that decade. As a result of this Japan stock bias, the category-relative performance of the index went from first to worst in a short span when the Japanese stock market crashed in the early 1990s. Since then, stocks from Japan have represented a smaller share of this index; they currently account for 23% of its market capitalization.

Second, many funds in the foreign large-blend category expanded into emerging markets not covered by the EAFE Index. Exhibit 2 shows that the average allocation to emerging-markets stocks in the foreign large-blend category has grown since the late 1980s. The MSCI EAFE Index does not capture the opportunity set that is available to active managers in the category. This effect was particularly pronounced from January 2001 through June 2017. During this span, the MSCI Emerging Markets Index returned 9.5% compared with 4.1% for the EAFE Index.

Third, funds in the foreign large-blend category collectively tilt toward mid- and small-cap stocks, as evidenced by the category’s average market capitalization. Exhibit 3 shows how this measure of size has evolved over time for the category and EAFE Index, with the index consistently larger than the category norm. This shouldn’t come as a surprise, as the EAFE Index focuses on large- and mid-cap stocks.

Exhibit 3 also shows the average market capitalization of the MSCI EAFE Investible Market Index, or IMI. This index covers the same countries as the standard EAFE Index but extends its reach to include small caps, and it effectively represents the broader investable universe of stocks listed in these countries. Its average market capitalization has consistently been below that of the category norm. This inclusion of small-cap stocks allowed the IMI version of the EAFE index to post better returns than the standard version.

Adding emerging-markets stocks also would have helped, as the performance of the MSCI ACWI ex USA Index demonstrates. This benchmark covers the same developed markets as the EAFE index, but it adds emerging-markets stocks to the mix. That said, emerging-markets stocks’ strong performance during this period may not persist.

The result of diversifying across a broader selection of countries and the inclusion of small-cap stocks not only improves category relative performance, but also enhances absolute and risk-adjusted returns. Index fund investors can take advantage of these benefits through several widely available funds. IShares Core MSCI EAFE ETF tracks the MSCI EAFE Investible Market Index, while  iShares Core MSCI Total International Stock ETF directly tracks the MSCI ACWI ex-USA Investible Market Index. Another solid choice is  Vanguard Total International Stock ETF , which tracks the FTSE Global All-Cap Ex-U.S. Index and is nearly identical to IXUS with an 89% overlap among their holdings. All three of these funds land in the foreign large-blend category and have Morningstar Analyst Ratings of Silver.

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Daniel Sotiroff does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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