IWD - IEFA Gets Some Things Right Multiple Is Low

Summary

• IEFA focuses on Europe, Asia, Australia and the Far East, but with no China, which is a good start.
• These markets are pretty cheap right now, and an outsized allocation in the portfolio is to financials.
• Some of the large allocations within financials are neutered by their markets, but there are more than 3,000 holdings, so the effects are limited.
• Otherwise, the sectoral breakdown is alright, but not great.
• The P/E ends up being pretty low, implying a decent earnings yield, but there's nothing special about IEFA. Pass.

The BTC iShares Core MSCI EAFE ETF ( IEFA ) covers some interesting parts of the markets, eschewing U.S. exposures entirely for other developed markets. In doing so, they avoid the overvaluation of U.S. markets. However, taking pretty broad bets on these other developed economies, with some of the good sectoral exposures, come some bad ones, too. The largest allocation seems strong, but a lot of them below it are quite levered to the risk factors of today's markets. Overall, we just aren't compelled in any special way by IEFA.

IEFA Breakdown

IEFA focuses on the major non-U.S. stock markets. It ends up with lots of Europe, Japan, UK, and Australia. There is no significant emerging market exposure, unless you count the 3% in Hong Kong as an emerging market exposure.

The Japan exposure is worth focusing on a little more, particularly. We consider this to be a weak area for two reasons. While there are actually some of the best value deals on Japanese markets, on a broad exchange-traded fund ("ETF") basis it poses foreign exchange ("FX") risks, and it weakens the financial exposure in the sector breakdown, which features many Japanese financials.

On the FX side, the Yen is a very poor-performing currency right now because the Bank of Japan ("BoJ") is maintaining very accommodative interest rate regimes. This is because inflation hasn't been as bad in Japan, due partly to the very muted and demographically beleaguered economic environment that has persisted for decades. With inflation coming up a little bit on a core basis, perhaps the BoJ will have some explaining to do and may have to justify continued stimulus. However, so far it has been the outlier among central banks and has given no indication that the situation for the yen and Japanese government bonds will change.

In a similar vein, where financial exposures in most economies are benefiting from a rate hike environment, where lending rates are moving ahead of savings rates and where yields on insurance reserve portfolios are rising, the relatively meaningful allocation to Japanese financials will be seeing none of these effects as monetary stimulus continues there. There are also some other idiosyncratic financial exposures like AIA Group ( AAGIY ), which aren't benefiting from rate hikes due to duration decisions. Overall, in other ETFs like the iShares Russell 1000 Value ETF ( IWD ), the financial exposures are a little better positioned. Thankfully, with over 3,000 exposures in the IEFA, Japan cannot ruin things entirely with plenty of other nations that are doing rate hikes present within the financial allocation, too, but it is a thought.

Where financials could have been more of a bright spot, the rest of the allocations look a little more poor with the exception of healthcare, which is typically very resilient, especially in larger-cap biopharma. Industrials are a mixed bag. It includes manufacturers of consumer durables, but also other capitally intense companies which have to deal with a retreat in spending cycles, particularly in Europe. Moreover, inflation effects here are mixed. Some industrial players can outrun it, others absolutely can't. Industrials aren't an unambiguously good place to be overall.

Consumer discretionary, on the other hand, is almost certainly a bad place to be as it would involve a lot of car exposures and other products that are to a larger extent levered to economic cycles. Industrials are 16% and consumer discretionary is 11% of the portfolio, so a meaningful amount.

Conclusions

The IEFA has a P/E of around 12x, which implies a decent earnings yield of around 8%. That gives you some spread over the reference rate. The problem is that the P/E is based on trailing figures, and consumer discretionary and industrials are more likely to see earnings decline, which would reduce that earnings yield. As reference rates move ahead of the 4% level, that isn't such a good yield after all, given the risk you're taking in complicated equity markets. The yield is 4.6%, which is nice, but in general, falling earnings, both from higher financial costs but also from the demand side contracting, do not necessarily guarantee these yields as would be the in a REIT ETF , for example. There's nothing too exciting about IEFA. IEFA is a pass.

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