Highlighting Some “EAFEC ETF” Options

by on May 17, 2011 | ETFs Mentioned:

Most investors constructing an equity portfolio using ETFs would segment the asset class into three distinct sections: U.S. equities, emerging markets, and ex-U.S. developed markets. The least exciting of those three is probably the last one, given the dismal performances turned in by Europe and Japan in recent years, as well as the significant obstacles that remain in those markets going forward. While more active traders may prefer to avoid most developed markets outside of the U.S. in the current environment, those seeking balance and embracing a long-term approach will understand the potential diversification benefits and return enhancement possibilities this asset class can offer.

To many investors, the EAFE region has become synonymous with ex-U.S. developed markets. Much like the BRIC bloc, the countries included under the EAFE umbrella have very little in common from a geographic, cultural, or even economic perspective; the European, Australasian, and Far East markets are instead a collection of the largest and most important developed economies outside of North America.

Those last few words are worth considering a bit more closely; the EAFE region is not an ex-U.S. collection of advanced markets, but rather an ex-North America grouping. And as such, it excludes not only the United States, but Canada as well. That means that investors who use EAFE ETFs such as VEA or EFA are missing out on a resource-rich economy that happens to be among the ten largest economies in the world, and one of the six largest ex-U.S. developed markets (Canada’s economy is considerably larger than Australia, which accounts for a big weighting in many EAFE funds). VEA and EFA, both of which seek to replicate the MSCI EAFE Index, have close to $50 billion in AUM, highlighting their popularity with investors.

Canada’s economy is one of the more unique components in the global market, boasting not only an abundance of increasingly valuable natural resources, but a degree of stability and sound fiscal footing that is increasingly rare in the developed world. As such, it is difficult to declare any portfolio that misses out on this market truly balanced and diversified; while Canada probably doesn’t need to account for a massive portion of any long-term portfolio, it should certainly be represented in some amount [see a list of Canada ETFs here].

Adding Some Northern Exposure

If your portfolio is one of the many that completely overlooks Canadian equities, there are a few options for rectifying that oversight. One is to simply add pure play Canada exposure through one of the ETFs that focuses exclusively on that economy, including the large cap heavy EWC or the small cap focused CNDA [compare the two head-to-head].

Another option is to utilize a more broadly-based developed markets fund in place of an EAFE fund that passes over North America entirely. There are a handful of ETF options that offer up this mix of exposure, for those willing to take a closer look under the hood and plug a common hole in portfolio exposure maps [for more ETF ideas, sign up for our free ETF newsletter]:

Schwab International Equity ETF (SCHF)

This fund is linked to an FTSE index that includes large cap and mid cap stocks from more than 20 developed markets, including several from Western Europe, Japan, Australia, and Canada (which accounts for about 9% of the portfolio). There’s a lot to like about SCHF besides just the inclusion of our neighbors to the north; this fund has nearly 1,000 individual holdings, minimal concentration in any one name, and balance across a number of regions, countries, and sectors of the international economy. Moreover, SCHF is among the cheapest funds in the ETF universe; the 0.13% expense ratio is extremely competitive considering the nature of the exposure, and commission free trading for Schwab accounts further enhances the appeal to cost conscious investors [see Building An Ultra-Cheap ETF Portfolio].

SPDR S&P International SmallCap ETF (GWX)

This ETF delivers broad-based exposure to small cap stocks in developed markets outside the U.S., including an allocation of about 10% to Canada. GWX might make sense as a complement to the large cap and mid cap exposure offered by SCHF, offering a way to access companies that may be more reflective of local consumption patterns and the health of the developed market economies than their large cap counterparts. Small cap exposure may also help to balance sector exposure, and enhance the growth potential of this asset class [see For ETF Investors, The Details Matter].

PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (PXF)

This ETF may have appeal to investors looking for alternatives to market cap-weighted methodologies that can introduce potentially undesirable tendencies to an equity portfolio. Instead of using firm value to determine the allocation, PXF determines weighting based on four fundamental measures of company size: book value, income, sales and dividends. PXF includes all traditional components of an EAFE ETF, along with a meaningful allocation to Canadian stocks [see PXF holdings].

Disclosure: No positions at time of writing.