What’s the best way to invest in developed markets such as the United Kingdom, Germany, Japan, Australia and elsewhere? Well, one that stands out is by going through the MSCI EAFE Index.
The index, which was created by MSCI Inc. (NYSE:MSCI) in 1969, stands for “Morgan Stanley Capital International — Europe, Australasia and Far East.” Originally conceived by Morgan Stanley (NYSE:MS) as a 15-country index, today, the MSCI EAFE represents the stock markets of 22 developed countries, including those mentioned above. With more than 900 companies, the market-weighted index represents 84% of the free float-adjusted market capitalization in each country.
Of course, you can’t own the index itself — so the next best thing is to play it through an ETF.
There are two ways to accomplish your goal of owning the biggest stocks in the developed world (excluding the U.S. and Canada): buy an ETF that replicates the traditional MSCI EAFE Index, or buy an ETF that replicates the performance of the MSCI EAFE Equal Weighted Index.
As the latter’s name suggests, every stock in the index has the same weighting, rebalanced quarterly. By choosing an equal-weighted portfolio as opposed to a market-weighted one, companies such as Nestle (PINK:NSRGY) and HSBC Holdings PLC (NYSE:HBC) aren’t in the top 10. In addition, because some of the world’s biggest stock markets are located in Europe, the market-weighted index has a higher concentration of European stocks than the equal-weighted one. If you’re leery of what’s happening in Europe at the moment, the equal-weighted index brings greater global balance into play.
iShares MSCI EAFE Index
The iShares MSCI EAFE Index ETF (NYSE:EFA) is the larger of two possible market-weighted ETFs with total net assets of $38.8 billion compared to $7.3 billion for the Vanguard MSCI EAFE ETF (NYSE:VEA). Although the three-year performance of the Vanguard ETF is slightly superior to the iShares ETF, on a tax-adjusted basis, the iShares ETF comes out ahead. As of the end of December 2011, the EFA’s three-year, annualized after-tax return was 7%, 84 basis points higher than the VEA.
Morningstar uses something called the “tax cost ratio” that puts the costs of taxes in perspective. According to their data, EFA’s tax cost ratio over three years is 0.43, which means taxes consumed 0.43% of the net total assets over this period, compared to 0.57% for the Vanguard fund. So even though the Vanguard fund has an expense ratio of 0.12% compared to 0.34% for the iShares fund, it doesn’t do as well once taxes are taken into consideration.
Since its inception in August 2001, the iShares fund has achieved positive annual returns in seven of the last 10 years. It definitely qualifies as a core holding.
Rydex MSCI EAFE Equal Weight ETF
Rydex specializes in equal-weight ETFs, with a total of 18 in its arsenal. It created the first ETF in April 2003 with the Rydex S&P 500 Equal Weight ETF (NYSE:RSP). Rydex believes equal-weighted funds provide three distinct advantages over market-weighted ones:
- An equal-weighted strategy allows for smaller companies to improve performance when large caps — the bread and butter of market-weighted ETFs — aren’t doing as well.
- Equal weighting provides greater diversification across market capitalization, sectors and other risk factors.
- Quarterly rebalancing results in profit taking and the reallocation of those profits in out-of-favor components, lowering overall market risk while potentially improving the fund’s performance.
Rydex’s original S&P 500 Equal Weight ETF on both a pre-tax and after-tax basis has seriously outperformed the market-weighted SPDR S&P 500 ETF (NYSE:SPY) in the past five years.
The Rydex MSCI EAFE Equal Weight ETF (NYSE:EWEF) has an expense ratio of 0.55%, which is significantly higher than either of the market-weighted ETFs. Furthermore, its inception was December 2010, meaning it hasn’t had a chance to get out and show what it can do against its market-weighted peers.
However, since the MSCI EAFE Equal Weight Index was formulated by MSCI in January 2008, its annual return is -3.02% compared to -6.3% for the market-weighted version. With 24% annual turnover compared to 6% for both the EFA and VEA, time will tell how tax-efficient the fund is, but in the long term, it looks like a winner.
Bottom Line
Normally, the ETF with the lowest expense ratio tends to be the best investment choice. However, in this instance, Rydex’s fund must be a serious consideration for anyone looking at capturing the developed markets.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.
