A Foreign Equity Fund With Low Exposure to European Banks

At our annual Morningstar Investment Conference last week, it was no surprise to see many fund managers weigh in with their thoughts on the euro crisis. Templeton's Michael Hasenstab is optimistic that policymakers will move in the right direction to form a stronger fiscal union, and University of Michigan economics professor Jim Adams believes that while some of the smaller countries may drop out of the euro, the euro will survive because it's better than the alternatives. As for European equities, three value managers, as well as GMO's Jeremy Grantham, all see long-term value in the region, especially in companies with strong global operations.

Investors who think Europe is attractively valued and are willing to ride out potential higher volatility in the near term may want to consider  iShares MSCI EAFE Growth Index (EFG). We like this fund not for its style orientation but for its sector exposure--its top weightings are consumer staples (21%), industrials (15%), and consumer discretionary (15%). Many of these companies, such as  Nestle (NSRGY),  GlaxoSmithKline (GSK), and  British American Tobacco (BTI) are strong global players with good exposure to the faster-growing emerging markets. Most cap-weighted passive Europe or international developed equity funds tend to have a heavy weighting in banks, which may see margins negatively affected by rising exposure to bad debts and more stringent regulations in the coming years. EFG has a relatively low 8% exposure to the financial sector. Finally, while this ETF is not a Europe pure play, its 40% exposure to developed Asian markets results in a portfolio that is less volatile relative to a Europe-only fund.

Suitability
About 60% of this fund is invested in European equities, but only about 30% of the holdings are domiciled in the eurozone. (The United Kingdom and Switzerland do not use the euro.) MSCI style indexes anchor country weightings, so the geographic exposure of EFG and its parent index MSCI EAFE Index are almost the same. The 15-year annualized standard deviation of returns for the MSCI EAFE Growth Index was 18%, in line with that of the MSCI EAFE Index. We suggest using this ETF as a satellite holding, but it can be used as a core holding given its geographic diversification and the fact that its volatility has been in line with that of its parent index. This ETF can also be used as a tactical holding for those who want to control their value and growth exposure. This ETF's pair is  iShares MSCI EAFE Value Index (EFV).

Like most ETFs that invest in international equities, EFG does not hedge its currency exposure. Therefore, its returns reflect both asset price changes and changes in exchange rates between the U.S. dollar and other currencies. In the past decade, this ETF has benefited from the rise of the Japanese yen, the pound sterling, and the euro versus the U.S. dollar. So, while this fund's underlying index (in local currencies) returned an annualized 1.0% over the past 10 years (through May 2012), in U.S. dollars it returned 4.5%. Some investors use foreign equities to hedge against a potentially weakening U.S. dollar. However, we note that Japan and developed Europe have loose monetary policies and face rising entitlements and debt levels, which will likely weigh on each region's respective currency over the longer term.

Fundamental View
In the near term, we expect trading in European equities to be driven more by headlines regarding the debt crisis rather than by fundamentals. On the fundamental side, most of Europe's corporations have solid balance sheets (with the exception of the financials sector) but currently face slowing global growth and likely a very slow recovery in Europe as economies remain fragile, as banks deleverage, and as fiscally troubled countries cut spending to address rising budget deficits.

The 40% stake in developed Pacific markets consists mostly of Japanese companies, followed by Australian companies, which tend to have a cyclical tilt. There are a number of well-known issues that continue to weigh on Japanese companies, including sluggish domestic growth, a rapidly aging population, and a high yen, which hurts Japan's large-cap exporters. However, valuations for Japanese equities are very cheap, and balance sheets are generally healthy and flush with cash. Over the longer term, Japan's companies may benefit from emerging-markets demand for their capital equipment, consumer products, and electronic goods. As for Australia, its domestic economy faces some near-term headwinds, including a deleveraging private sector, a deflating housing sector, a more challenging operating environment for its banking sector, and the global economic slowdown (in particular, a slowdown in large-scale capital investments in China), which are weighing on Australia's commodity producers.

Portfolio Construction
This ETF tracks the MSCI EAFE Growth Index. The index represents approximately 50% of the MSCI EAFE Index (which includes stocks from 22 developed European and Asian countries) and consists of those securities classified by MSCI as growth stocks and proportional weightings in stocks that exhibit both growth and value characteristics. MSCI classifies a stock as growth, value, or both, using an eight-factor model: three for value and five for growth. The growth factors are long- and short-term forward earnings per share growth, historical EPS growth, sales growth, and internal growth. MSCI also employs buffer zones to limit migration between the growth and value categories. The fund follows a full replication strategy, holding 553 of the 555 securities in the index.

Fees
IShares MSCI EAFE Growth charges a 0.40% expense ratio. This is currently the only option for broad international developed growth exposure.

Alternatives
IShares MSCI EAFE Index EFA follows the parent index and charges 5 basis points less. Investors can also consider international "growthy" sector funds, such as SPDR S&P International Consumer Discretionary Sector and SPDR S&P International Technology Sector , each of which carry a 0.50% expense ratio. However, these funds are small and have low trading volumes.

An interesting option is the relatively new  iShares MSCI EAFE Minimum Volatility (EFAV), which attempts to create the lowest-volatility portfolio out of EAFE stocks while keeping sector and country weightings within 5% of their weightings in the MSCI EAFE Index. This ETF has a slight growth tilt. Like value stocks, low-volatility stocks have outperformed on a risk-adjusted basis over the long term in most markets. At this time, this ETF has a relatively low 17% exposure to financials and has had an annualized 10-year correlation to the MSCI EAFE Index of 93% and a lower 80% correlation to the S&P 500 versus the MSCI.

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Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management; First Asset; First Trust; Invesco; Merrill Lynch; Northern Trust; Scottrade; and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.