Today I would like to discuss the iShares MSCI EAFE ETF (EFA), quite a remarkable fund that allows investors to gain exposure to a broad list of developed economies. It has a modest standardized yield of 1.85% coupled with low volatility signified by a 0.88 3-year beta and a higher earnings yield compared to the S&P 500.
However, it also has a few disadvantages not obvious upon a cursory review. So let us delve deeper.
What the fund is focused on
As per the fund’s name, its essential purpose is to track the investment results of the market-capitalization-weighted MSCI EAFE Index. The index itself is focused on the large- and mid-cap public companies incorporated in the developed world outside the U.S. and Canada.
The EAFE acronym stands for Europe, Australasia, and the Far East. This region encompasses 21 developed economies: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, The Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the UK, Australia, Hong Kong, Japan, New Zealand, Singapore, and Israel.
Intricacies worth understanding regarding investing in the ‘developed world’
An investor who has an intention to increase the degree of portfolio diversification by purchasing equities outside the U.S. market, which is too generously valued at the moment (e.g., iShares Core S&P 500 ETF (IVV) has a P/E of 24.6x), can opt for going long shares of companies in the developed world or taking more risks with emerging markets, which may look especially alluring for yield-starved and value-oriented investors.
Gaining exposure to the developed economies certainly makes sense: while stock valuations are somewhat less generous than in the U.S. (EFA’s P/E is slightly south of 18x), these countries also have lower geopolitical risk, lower FX volatility, etc., if compared to emerging markets. But there is an essential issue with classifying stocks in such a manner: a country of incorporation is almost never a country where all the operations are concentrated.
Take EVRAZ plc (OTCPK:EVRZF), for example. In the EFA portfolio, it has a 0.02% weight. The company is listed on the LSE and has its corporate headquarters in London. With a ~£6.73 billion market cap, it is one of the most valuable London-quoted firms and a constituent of the FTSE 100. But its steel & coal operations are principally focused on Russia (like the ZSMK steel mill and the NTMK plant), the U.S. (for instance, the EVRAZ Portland rolling mill), and Canada (the EVRAZ Calgary, etc.). Interestingly, this steel industry heavyweight is also the constituent of the Dow Jones Emerging Markets Select Dividend Index, and thus its shares are among the holdings of iShares Emerging Markets Dividend ETF (DVYE), which I covered in August. So, what is the takeaway? Investing laser-focused on the developed world only, in fact, exists only on paper.
A deeper look at holdings
As of December 14 (the most recent data available), the fund had 912 holdings, 881 of which were classified as Equity. Other asset classes include Cash, Cash Collateral & Margins, Futures, FX, and Money Market.
Combined, the ten largest holdings account for only 11.9% of the overall portfolio. Only six equities have weight equal to or greater than 1%. The common stock of the consumer staples sector bellwether Nestlé S.A. (OTCPK:NSRGY) traded on the SIX Swiss Exchange and priced in CHF is EFA’s most significant investment with a 2.08% weight.
The fund has an interesting sector mix, which somewhat hedged it against the repercussions of the pandemic (thanks to its substantial exposure to healthcare, 12.8%), while also making it strongly positioned for the capital rotation, thanks to financials (16.3%) and industrials (15.2%).
At the same time, the market-darling IT sector that shone during the toughest months of the pandemic does not influence EFA’s returns significantly, given the tech cohort has only an 8.6% weight. Also, it is worth mentioning that the IT stocks in the portfolio are predominantly Japanese (36 stocks out of a total of 69).
Also, EFA has minuscule exposure to the energy sector (only 22 stocks with a total weight of 3.25%), which somewhat immunized it against the oil price slump that sent shockwaves through the petroleum industry.
Created by the author using the Detailed holdings & analytics dataset
Among the energy players in its portfolio are all non-U.S. supermajors like Royal Dutch Shell (both classes of shares: RDS.A and RDS.B), Total (TOT), BP (BP), Eni (E), and Equinor (EQNR). There are also a few major European integrated energy companies including OMV (OTCPK:OMVJF), Galp Energia (OTCPK:GLPEY), and Repsol (OTCQX:REPYY). I have covered all of these players at least two times since 2018.
Among notable E&P companies that I discussed in the past are Australian Oil Search (OTCPK:OISHF), Woodside Petroleum (OTCPK:WOPEF), Santos (OTCPK:STOSF), and Swedish Lundin Energy (OTCPK:LNEGY), previously known as Lundin Petroleum.
By the way, Oil Search, despite its ASX listing, produces oil & gas only in Papua New Guinea (for now). It also invests in the exploration and development of hydrocarbon resources in Alaska including the Pikka project. So, as I said above, due to globalization, it is almost impossible to invest exclusively in developed markets: companies with material market capitalization will inevitably have exposure to EMs.
Hidden flaws of the portfolio: inadequate country diversification
Yes, EFA has a sprawling portfolio. Does that mean its diversification profile is exemplary? Not exactly.
The issue is that the three countries are responsible for more than 50% of the portfolio, namely Japan, the UK, and France. Japanese stocks account for more than 25% of the total holdings. This is clearly a too-high level of country risk concentration. Importantly, an over 14% exposure to the British equities makes EFA’s price performance dependent on the gyrations of the pound sterling, and, hence, on the outcomes of Brexit.
What are the other ETFs focused on the EAFE?
There are a few ETFs focused on the same region, including the following:
- iShares Core MSCI EAFE ETF (IEFA), with 2,656 equities in the portfolio,
- iShares Edge MSCI Min. Vol. EAFE ETF (EFAV), with a much leaner portfolio of just 257 stocks,
- iShares MSCI EAFE Value ETF (EFV), with 537 holdings,
- iShares MSCI EAFE Growth ETF (EFG), with a portfolio of 440 equities.
EFA has also ESG-focused alternatives like the iShares ESG Aware MSCI EAFE ETF (ESGD) and the iShares ESG Advanced MSCI EAFE ETF. Quite expectedly, not all energy players are welcome in their portfolios. For example, ESGD has only 13 energy stocks (Shell, Oil Search, and a few others did not qualify for the inclusion), while the ETF with advanced ESG criteria has no exposure to the sector, at all.
The author’s work. ESGD and EFA energy holdings comparison. Companies marked with white are not presented in the ESGD portfolio.
The chart below illustrates quite vividly that EFG and EFAV easily trounced the other funds in the last ten years. The weakest total return was delivered by value-focused EFAV, given the previous decade was not especially successful for value investing.
Source: Seeking Alpha
But if take a look at a shorter period, the last six months, we will notice that EFV performed well, while healthcare-heavy EFAV was a laggard, which can be explained by the capital rotation.
Source: Seeking Alpha
S&P 500 easily outperformed the EAFE-focused ETFs
The bitter truth about EFA and the related ETFs is that their long-term total returns are subpar if compared to the tech-heavy S&P 500.
Source: Seeking Alpha
Still, the 6 months returns are almost similar.
Source: Seeking Alpha
By adding the iShares MSCI EAFE ETF to their portfolios, investors can gain exposure to a broad range of developed countries and thus meet their diversification targets. However, it is worth remembering that it is impossible to focus exclusively on the developed world, and the portfolio will, in any case, be more or less tied to the emerging markets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.