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Portfolio > ETFs > Broad Market

Just Your Cup of Tea

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Fuzzy math. Corrupt leaders. Accounting scandals–and an accounting system that is clearly broken with no fix in view. Political volatility. Economic vulnerability. Markets swinging on a loose and fast hinge. In the good ol’ days, we’d be talking about foreign markets. But, in case you haven’t noticed, the Wild West is back–and it’s high noon in the U.S.A, or at least in the U.S. markets.

Not surprisingly, many of your clients are likely clamoring for investment options beyond our pale, if not stampeding for a bond corral. While the latter move may salve the equity wound, it’s only one step in a strategic portfolio’s direction. The other is to hedge our markets’ volatility with other markets that don’t correlate all that closely. But does investing overseas make fundamental sense? Or is the second accounting scandal sandal about to drop over there? For answers, we’ll take a quick trip there and back via two investment vehicles, and a host of information dedicated to Europe and its niche marketplaces.

First, a brief history. A little over two years ago the concept of investing in Europe was, to put it mildly, a tough sell. The U.S. market was faring well, with the S&P 500 index up over 20% for five years in a row. Conservative clients no doubt asked why they should be invested anywhere else when the U.S. market just kept going up. The fact that overseas markets were all badly lagging in the long term didn’t help the idea pass port. Under the circumstances, Europe’s claim to being a better “value” than other markets rang hollow even to those who believed in the concept of value investing.

No doubt your more aggressive clients also found Europe a tepid idea. Their favored technology and telecommunications stocks dominated the news with explosive returns while the minority who would consider overseas investments were likely fixated on the fact that Japan had just put in a great year, with many Japan-focused funds up over 100% in 1999.

Today, the same clients might be asking you why they’re not invested in Europe. For the two years through June 2002, the S&P 500 is down 30%, the tech-heavy Nasdaq Composite index is down 63%, and Morgan Stanley Capital International’s Japan index has declined 46%. In that light, the MSCI Europe index decline of 30% seems pretty reasonable. That’s about the same decline as the S&P 500. But the lesson that the U.S. market can still go down, combined with the fact that its long-term bull market and shorter-term profit recession still leaves it remarkably expensive in global terms, makes putting a portion of assets overseas look increasingly like a smart move. (Due to falling earnings, the S&P 500 recently featured a trailing price/earnings ratio of 40, up from 26 a year earlier; its price/book ratio has fallen a bit, from 5.9 to a still high 4.6.)

There are, of course, many roads to investing in Europe, with solid Europe-focused large-cap stock funds from Ivy, Fidelity, Merrill Lynch, AIM, Putnam, and T. Rowe Price, among others. Certainly these are worth a look, especially for investors in tax-deferred retirement accounts, but regular readers of this column know that we also cast an eye in the direction of the exchange-traded fund (ETF) concept of index investing. ETFs are traded like stocks (generally on the Amex), with no loads (just regular stock-like commissions), and generally lower expenses, turnover, and taxable distributions than can be found even in most index mutual funds.

Naturally, with any index fund the primary “complaint” is that you’re forced to settle for middling returns. That’s true as far as it goes, but if you like a sector or market, achieving that index return might be quite appealing. Further, since actively managed funds have higher expenses, turnover, and (often taxable) distributions, most active funds will lag the market, so “middling” is actually above-average. On the other hand, a well-chosen managed fund ought to beat the market, especially in less efficient and/or smaller-cap markets. (See my report on the AIM European Small Company fund, which follows.)

The ETF du mois is the iShares S&P Europe 350 Index fund (IEV). Naturally, the IEV seeks to closely track the S&P Europe 350 Index, which measures the performance of equities in the 12 “euro zone” countries, plus the U.K., Denmark, Norway, Sweden and Switzerland. The index and the fund, which are approximately market-cap weighted, cover about 70% of the total stock market capitalization in these European countries, and are diversified across sectors. They should always have a large-cap “blend” style.

Like the S&P 500 index in the U.S., the S&P Europe 350 stocks are approximately, but not exactly, the 350 largest in the region in terms of market capitalization. Other factors that keep the index from exactly corresponding to the 350 largest stocks are sector representation, liquidity, and a desire to minimize index turnover. Rather than sell a stock every time market action puts it at the 351st spot on the European market-cap list, index deletions are generally forced by bankruptcy, acquisition, or a spin-off; and index additions are made only to fill index vacancies.

While the iShares S&P Europe 350 Index fund has only been around since July 2000, that’s not really a drawback for an ETF or, really, any index fund from an established fund family. The IEV recently had almost 11 million shares outstanding, and at a recent share price of $56 that gives it a market cap of $600 million. Further, the structure of ETFs means new shares can be created or eliminated to meet just about any market demand, so liquidity is not a problem.

The fund’s sponsor, Standard & Poor’s, offers market commentary for the S&P Europe 350 (and other markets) that should interest Europe investors whether or not the iShares Europe 350 is their chosen fund vehicle–it’s available at (More on this site and other sites in my article on Europe-focused Web magazines below.)

The IEV’s expense ratio of 0.60% is a bit higher than for a domestic large-cap index fund, but is quite low for an international fund. The cheapest similar index offering, the Vanguard European Stock Index (VEURX), has an even lower 0.30% expense ratio; it tracks the Morgan Stanley Europe Free index, with just over 500 holdings. Despite the Vanguard fund’s longer “tail” (basically a modest position in mid-large cap stocks) the funds will always show very similar top positions lists, as well as sector and country weightings, and returns.


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