Is It Crazy to Own an EAFE Index Fund?

In a recent Fund Spy column, I explained how the MSCI EAFE Index remains the most popular benchmark for foreign-focused mutual funds even though it's outdated in important respects. Here, I'll look at the topic from the perspective of index-fund investors. Are EAFE-tracking index funds now obsolete? If so, why have they been drawing investors by the basketful?

The Days of EAFE-Trackers Might Be Over
The MSCI EAFE (which stands for Europe, Australasia, Far East) Index, which excludes emerging markets, has long been the standard benchmark for broad foreign funds. That made sense when emerging markets were viewed as too risky for most mainstream international funds to venture into. But now, managers who completely ignore emerging-markets stocks are few and far between. And Canada, also left out of EAFE, isn't a bit player anymore: A strong economy and currency, plus a natural-resources boom, has made that country's stocks common in many foreign-fund portfolios, too.

Therefore, it seems out of step for so many index-fund investors to have poured money into  iShares MSCI EAFE Index (EFA) in the past few years. That vehicle has become the second-largest of the hundreds of exchange-traded funds on the market, with nearly $50 billion in assets. (Only the original  SPDRs (SPY), which tracks the S&P 500 Index, is larger.) Some EAFE-tracking vehicles in the conventional mutual fund format also continue to attract substantial assets.

This attraction to an outdated index seems hard to justify. If an investor's only foreign fund is that giant iShares ETF or another EAFE-tracker such as  Vanguard Developed Markets Index  or  Fidelity Spartan International Index , the investor is restricted to a rather limited universe. No stocks from Canada, India, Israel, Brazil, Taiwan, or South Korea, among others. Let's leave aside the conventional opinion that emerging markets offer the potential for greater gains because of their faster rates of economic growth. More to the point, these days, by omitting all those countries, a fund manager is simply cut off from an uncomfortable amount of high-quality, world-class companies.

Then Again, Maybe Not ...
However, a closer look reveals that investing in an EAFE fund can in fact be a reasonable choice. After all, while the EAFE-tracking vehicle from iShares is the second-biggest exchange-traded fund, the third biggest, with about $25 billion in assets, is the iShares portfolio that tracks MSCI's emerging-markets index. It's quite possible that many of the EAFE fund's shareholders--who are mostly institutions, reports indicate--are pairing it with its emerging-markets sibling. If so, that compensates for the EAFE portfolio's main shortcoming.

It's possible that many individuals who own EAFE-tracking conventional mutual funds are doing the same thing, picking up an emerging-Asia fund or a broader emerging-markets fund, whether index-tracking or actively managed, to supplement their core offering. They might also own a foreign small-cap fund, thus filling another gap. In this way, an international portfolio with EAFE at its center can actually be a broadly diversified mix.

Meanwhile, in the summer of 2007, new index-tracking vehicles appeared that do include emerging markets and Canada in addition to the EAFE countries. And they don't go light on the emerging markets, either. It's impossible to know what the "right" allocation to emerging markets would be for every investor, but it's noteworthy that  Vanguard FTSE All-World ex-US  has 19% of assets invested in markets deemed emerging by MSCI. That's much more than most actively managed funds have. Another new entrant with a tongue-twister of a name, SPDR MSCI ACWI (ex-US) (CWI), has roughly 16% of assets in emerging markets. If the emerging-markets rally regains its strength after a November slide, the larger that component will grow in these funds. It would be understandable if cautious investors would rather manage the size of that stake themselves, by owning one fund for the EAFE countries and a separate one for emerging markets.

Different Funds for Different Purposes
That gets to the key point. Despite being outdated in major respects, EAFE, or rather EAFE-tracking funds, can still serve certain investors well. Some might specifically want that type of limited portfolio, either to purposely avoid emerging markets or to manage the emerging-markets weighting themselves using separate funds.

Conversely, for investors who want just one index fund to serve as their sole, long-term exposure to international markets, the newer, broader options (or old standby  Vanguard Total International Stock Index (VGTSX), which includes emerging markets, though not Canada) are more logical choices than an old-fashioned EAFE fund. (And of course, for those not wedded to indexing, there are many top-flight actively managed foreign funds that also provide this type of broad geographical reach.)

Investors choosing a broader alternative, though, should be aware that they won't always beat EAFE funds; at some point, emerging markets will go though a period of underperformance. (At least that's the theory, even if the experience of the past five years or so may seem to indicate otherwise.) In short, while it's hard to fully defend the structure of the MSCI EAFE Index right now, and--as discussed in the previous column--to explain why the vast majority of actively managed foreign-stock funds still use it as their benchmark, it's easier to understand how some investors can use an EAFE fund to provide an anchor for a reasonable, diversified portfolio.