When it comes to picking an ETF, many investors stick with the big dogs. The largest market-cap weighted funds often see the highest trading volume and assets under management. Given that framework, most investors stick to just one or two funds in their search when choosing their portfolios. Nowhere is that more prevalent than in European equities allocations.
Both the Vanguard FTSE Europe ETF (VGK ) and the iShares Europe (IEV ) contain the vast bulk of investor money and interest. The VGK and IEV are both fine funds for broad allocation to Europe. However, investors may be selling themselves short if they only focus on the “big dogs” when it comes to Europe. There are numerous options for investors looking to tap into this corner of the market.
Here’s ETFdb’s list of the various alternatives.
The Problems with Market-Cap Weighted Europe ETFs
The beauty of the broad market-cap weighted European ETFs is in their broadness. In the case of the VGK, you get access to hundreds of firms domiciled in multiple nations across a multitude of sectors-all within one easy-to-trade ticker. You want to instantly add Europe? Boom, here it is. So it’s easy to see why the VGK, IEV and SPDR EURO STOXX 50 ETF (FEZ ) are very popular with portfolios.
But that simplicity does come with a set of drawbacks.
The problem with VGK, and with most market-weighted indexes in general, is several fold. To start with, as an individual stock gets more expensive, its index weighting can grow significantly. That leaves the overall value of the index vulnerable if the stock reverses course and begins to crash. Smaller, faster growing firms can’t pull their weight, while larger, slower growing ones have more influence on the index. That combination drags on potentially market-beating returns.
Broad-pan European ETFs expand on this problem. It’s not just stocks that can get expensive, it’s whole countries. As investor favoritism with various nations ebbs and flows, a similar problem occurs with regards to country weightings. Some nations can get rather expensive relative to others and the same crash potential can occur. That is, if the nation’s returns can get over the fact the United Kingdom is by far the largest weighting in almost every broad European ETF; the U.K. makes up about 33% of VGK’s holdings alone (as of 8/4/2015).
And since we are dealing with multiple nations, multiple currencies and their effects can also play a huge role in returns. Pounds, euros, krona, and francs all move in different directions against each other and the U.S. dollar. This creates a different set of headaches for investors when translating those returns back into dollars. In fact, currency movements can actually cause positive returns to become negative ones when shifting back out of a foreign currency into a local one.
Moving Outside the Box
Given the potential problems with using a market-cap weighted ETF like VGK, investors may want to look at some of the alternatives as either a complement to the larger market-cap weighted European ETFs or as a replacement. There are many diverse strategies and styles of ETFs that go against the grain or construct their indexes in a unique manner in order to outperform the larger pan-European ETFs. Here’s how the 63 different European ETFs are basically broken down.
Currency Hedged: Many investors often do not realize that there is a two-part total return quotient to foreign assets: how the stock performs in its local currency and how that currency performs relative to the dollar. This relationship can mean the difference between gains and losses depending on how things are moving. The latest trend for ETF issuers is to take that relationship out of the picture and solely focus on the stocks’ returns.
These currency hedged ETFs, such as WisdomTree Europe Hedged Equity ETF (HEDJ ) and Deutsche X-trackers MSCI Europe Hedged Equity (DBEU ), use derivatives to smooth out the currency bumps in each fund. In 2015, that has been a boon for the ETFs considering the rising dollar. Their hedges have helped them outperform their non-hedged rivals. However, the relationship is a two-way street. A falling dollar will crimp some of these funds’ returns.
Alternative Weighting: If the issue of market-cap weighting really comes down to size and the potential “expensiveness” of certain stocks and nations, then the birth of unorthodox indexing hopes to circumvent this issue. Smart-beta, scientific-beta, and factor-based investing–or whatever you want to call it–looks to craft better indexes than the bread-and-butter favorites. These ETFs will use screens that search for various fundamental metrics such as P/E, PEG, profitability, and revenue growth, and momentum factors such as relative price, and moving averages, to create a rules-based index.
Aside from choosing the initial factors, smart-beta ETFs have zero human influence and combine the best features of active and passive funds into one package. And since these smart-beta funds can focus on numerous different factors, they range from the very complex to the very basic. For example, the more complex First Trust Europe AlphaDEX ETF (FEP ) looks at month-price appreciation, sales-to-price and sales growth, book value, cash flow-to-price and return on assets to create its portfolio.
Small-Caps: While exposure to small-caps domiciled in the United States is a pretty common portfolio element, European small-caps are often completely ignored. That’s a shame as the asset class does have plenty of benefits, including faster growing earnings and revenues. Additionally, European small-caps offer the ability for investors to play “the real Europe.” These aren’t necessarily multinational operations and most of their sales come from operating in their region. That provides a different opportunity set for investors. The iShares MSCI Europe Small-Cap ETF (IEUS ) and SPDR EURO STOXX Small Cap ETF (SMEZ ) are two prime examples of broad-based European small-cap ETFs.
Dividends: It’s no secret that dividends have been one of the keys to long-term stock performance. Numerous studies have shown that fact. Well, the same can be said for European stocks. The difference is just how they pay out those juicy dividends. Unlike many American corporations that pay out the same amount each quarter (until they increase it), many European firms pay out a set percentage of profits twice a year. That means if profits go up, so will your dividend, and vice versa. That makes using ETFs a prime way to get your European dividend fix and avoid the wonkiness of pay outs thanks to diversification. The First Trust STOXX European Select Dividend ETF (FDD ) makes easy work of adding a group of Europe’s strongest payers.
Low Volatility: While it’s a common term thrown around by journalists and financial bloggers, many people don’t understand what it actually is. Basically, it’s the amount of uncertainty or risk regarding the size of changes in a security’s value. Another way to look at it is that a security’s price can change dramatically over time, up or down. Too much volatility and you can actually cripple returns. To that end, a low volatility approach can help smooth out the roller coaster, increase returns, and help you sleep at night.
The iShares MSCI Europe Minimum Volatility (EUMV ) screens for stocks that exhibit lower volatility characteristics relative to the broader European developed equity markets. That helps capture much of the upside of European stocks, while limiting some of the downside. And given just how bumpy things have been over the last few years, a lower volatility strategy may not be such a bad idea.
The Bottom Line
There’s a whole world of European ETFs outside of the largest market-cap weighted funds. By expanding their horizons and either replacing or supplementing their core exposure, investors have to the opportunity to custom-make their portfolios for greatness. With more than 60 ETFs, there’s no excuse not to.
Disclosure: No positions at time of writing.