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Is There Value in European Equity ETFs?

Maybe not, as austerity measures, bank deleveraging, and potential political instability create a challenging operating environment in the near and medium term.

Patricia Oey, 04/20/2012

European equities' low valuations may present an attractive long-term investment opportunity. If you're looking to access this market, Vanguard MSCI Europe ETF VGK is a great way to gain exposure. However, we would tread lightly here. In the near term, we expect trading in European equities to be driven more by headlines regarding the debt crisis rather than by fundamentals. And over the longer term, there is plenty of uncertainty over Europe's ability to effectively contain the ongoing crisis.

To date, European leaders have mainly reacted to issues when they bubble to the surface and have yet to address the root causes of the crisis, which include a lack of fiscal integration and trade imbalances within the eurozone because of different degrees of competitiveness among the member countries. Recently implemented initiatives, such as fiscal austerity in the troubled peripheral countries as well as in the United Kingdom, will likely stunt, if not choke, growth for the next few years and exacerbate the precarious fiscal situation of these countries. And any growth-friendly monetary easing by the European Central Bank, or ECB, in the near term may be constrained as inflation trends higher than expectations.

Banking Sector Woes and Potential Political Instability Banks, which account for about 18% of this fund, are facing rising capital requirements, rising bad debts, and higher funding costs. Bank deleveraging will result in a tightening credit environment, which will further constrain a very slow economy and, in turn, further weaken the banking sector.

The ECB has recently taken steps to support the continent's banks with its EUR 1 trillion long-term refinancing operations, which provided much needed liquidity to banks and helped bring down sovereign debt yields as banks used some of the funds to purchase their country's debt. However, the effect of this liquidity boost were short-lasting: By April, Spain's borrowing costs returned to 2011 highs, reflecting the market's increasingly pessimistic view about Spain's fiscal situation, and raised concerns about its banks' high exposure to Spain's sovereign debt. The scenario can play out across the other fiscally troubled nations over the next few months.

Finally, we highlight that France, Greece, and Ireland will have key elections in May. Given the high levels of unemployment and the weak economic environment, we would not be surprised to see changes in leadership in these elections and in future elections across most Europe. Changes in leadership will make it difficult to make meaningful necessary reforms that would support the future health and viability of the eurozone.

Suitability
Over the past 10 years, VGK's performance has had about a 91% correlation to that of the S&P 500. But we think investors should have some (albeit underweight) exposure to European equities, as they account for about 25% of the world's market capitalization.

This exchange-traded fund is suitable as a core holding and is our pick for passive European equity exposure. It is fairly diversified and holds many high-quality, strong global players with good exposure to faster-growing emerging markets. Most of this ETF's top 20 holdings, which account for about 30% of the portfolio, have narrow or wide moats, such as Royal Dutch Shell RDS.A, Nestle NSRGY, HSBC HBC, and Novartis NVS.

Like most international-equity ETFs, VGK does not hedge its foreign-currency exposure. As such, its returns reflect both asset-price changes and changes in the U.S. dollar and European currencies exchange rates. About half of the portfolio is in eurozone countries, with the other half in currencies such as the pound sterling and the Swiss franc. Thanks to the strong appreciation of these European currencies at certain time periods over the past decade, this fund's underlying index's 10-year return to March 30, 2012, (in U.S. dollars) was 6.0% versus the 2.4% return of the index in local currencies. Looking forward, it is more likely that this foreign-currency exposure will be a drag on the performance of this ETF given the ongoing eurozone sovereign debt crisis.

European equities are higher-yielding relative to their U.S. counterparts, and at this time, this ETF has an attractive yield of more than 4%. Investors should note that over the past few years, about 20% to 30% of this ETF's dividends were not considered qualified. Historically, this fund has paid out dividends once a year, but starting in September, it will pay out dividends quarterly.

Portfolio Construction
This ETF tracks the MSCI Europe Index, which is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of 462 companies in 16 developed European countries. The top country holdings are United Kingdom (34% of the portfolio), France (15%), Germany (13%), and Switzerland (12%). Relative to the S&P 500, VGK has heavier weightings in financials, materials, and telecoms, and lower weightings in information technology. This fund does not hedge its foreign-currency exposure.

We cover a number of single-country ETFs, including iShares MSCI United Kingdom Index EWU and iShares MSCI Germany Index EWG. Those interested in learning more about the outlook for some of VGK's larger country allocations can review our reports on those specific ETFs.

Alternatives
Vanguard considers itself a low-cost leader in the fund industry, and this ETF's fee of 0.14% is by far the lowest among comparable Europe ETFs. IShares S&P Europe 350 Index IEV is very similar to VGK in terms of holdings and performance. However, IEV is much more expensive, with a fee of 0.60%. IShares MSCI EMU Index EZU is also a pan-Europe fund, but it holds only companies listed in countries that have adopted the euro. As a result, EZU does not hold any U.K.- and Switzerland-domiciled firms (which together account for about 43% of VGK's portfolio) and has much heavier weightings in France, Germany, and Spain. EZU's management fee is 0.52%. A cheaper eurozone option is SPDR EURO STOXX 50 FEZ, which charges 0.29%.

Investors who want more control of their country allocations can consider iShares' family of single-country ETFs such as EWU, EWG, iShares MSCI France Index EWQ, iShares MSCI Switzerland Index EWL, and others.

Patricia Oey is an ETF analyst at Morningstar.
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