EAFE markets: Regional and country strategies

Investing in international stocks can help Canadian investors diversify their portfolios, gaining exposure to a wider range of countries, currencies and sectors than they might get from a typical basket of U.S. and Canadian stocks.

The simplest way for Canadian investors to hold international stocks is through a passive strategy that holds a single ETF or mutual fund. This approach covers off hundreds of stocks in 21 developed countries outside North America. This market is commonly known as EAFE, which denotes Europe, Australasia and the Far East.

If investors have conviction that certain regions or countries will perform well, they may find that a single EAFE fund is too broad for their liking. In this case, investors can select specific regions or countries. In this article, we outline regional and country strategies to invest in EAFE:

• The regional strategy is a minimally active approach, in which you hold 2 index funds to cover the key regions of Europe and Asia-Pacific.
• The country strategy is an active approach, in which you hold a selection of index funds based on specific countries. This strategy has the potential to significantly outperform or underperform the passive strategy of holding a single EAFE index fund.

1) Similar weights

Europe and Asia-Pacific have been at broadly similar weights in EAFE over the long term.¹ The regional strategy would be quite different if one region were consistently much larger than the other. In this case, a 50-50 regional strategy would amount to an active allocation to one region over the other.

2) Long-term mean reversion

Europe and Asia-Pacific have tended to oscillate in terms of long-term performance since 1970 — neither region has been the top performer in every decade. This provides an opportunity for the lower-performing region to revert to its long-term average level of performance. 

3) Periodic rebalancing

Investors need to rebalance their portfolios periodically to capture any potential benefit from the regional strategy. With rebalancing, investors reduce exposure to the region with stronger recent performance and increase exposure to the region with weaker recent performance, expecting that mean reversion will occur.

Investors looking for a more active approach can also select single countries in the EAFE market. There are currently 21 EAFE countries to choose from. Investors can use similar strategies to research countries that they might use to research individual stocks. Here we’ll consider 3 strategies: fundamental, valuation and technical.

Fundamental

One strategy to select countries is based on fundamentals. For countries, this means the performance of the economy. As it turns out, the correlation between GDP (gross domestic product) growth and stock market performance is uncertain and can even be negative.² While GDP growth translates closely to aggregate earnings, it doesn’t translate closely to EPS (earnings per share) growth, nor does EPS growth translate closely to increases in stock prices. This is due to a variety of reasons, including:

• A significant part of GDP growth comes from new companies that current investors may not own, which can dilute these investors’ stock returns relative to GDP growth. In turn, this dilutes aggregate stock returns relative to GDP growth.
• GDP growth tends to be affected by country-level conditions, while stock market performance tends to be affected by global conditions.³

Bottom line: GDP may be more useful as a negative signal than a positive signal. A low or declining level of GDP growth might be unwelcome for investors — but a high level of expected GDP growth says little or nothing about how a country’s stock market is likely to perform. 

Valuation

A 2nd strategy to select countries is based on valuation. The Shiller CAPE ratio measures inflation-adjusted earnings over a 10-year period, to check where prices are in relation to the trend of earnings over a full business cycle. This metric has proven to be very effective at assessing long-term valuation of stock markets. However, it's far less effective in telling investors specifically when to buy and sell. For example, the Japanese Shiller CAPE ratio reached a very high level in the mid 1980s⁴. If investors had sold right away, they would have missed out on 4 more years of remarkable gains. Stock markets can resist the gravity of earnings for a long time, until they eventually return to earth.

Bottom line: Use the Shiller CAPE ratio for long-term valuation, not short-term trading or investment decisions.

Technical

A 3rd strategy to select countries is based on technicals. ETFs and mutual funds are available for a wide range of countries, with U.S.-listed ETFs offering a particularly wide selection. Investors can compare country ETFs based on factors such as relative strength or excess return relative to a global stock benchmark. Services are available to monitor and track the performance of global ETFs. For example, CIBC World Markets’ monthly top 10 best ideas, a research report authored by Sid Mokhtari, includes a technical ranking of global ETFs and a visual of performance in quadrants. 

Bottom line: Technical analysis of global ETFs may be suitable for investors who want to actively manage their exposure to individual countries. However, technical analysis doesn’t explicitly include economic or valuation factors.

Investors have several strategies to invest in international stocks. Each strategy involves a different level of activity and conviction about international markets. 

Passive

Single EAFE fund, which provides diversified exposure to hundreds of stocks across 21 countries.

Minimally active

Regional strategy, which holds 2 index funds at equal weight: one for Europe and another for Asia-Pacific. Investors may potentially capture some gains from rebalancing, assuming the 2 regions revert to their average level of long-term performance.