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.
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