VT - IEFA: Heavy EU Exposure May Be A Drag

Summary

• IEFA offers low cost ex. US and Canada exposure to developed markets, resulting in EU-heavy portfolio.
• Mild weather may have saved Europe for now, but the energy crisis is far from solved.
• Historical data indicates that removing US and Canada exposure leads to inferior returns.

Some investors like to exclude US and Canada from their portfolios. This could be achieved through either individual stock picking or with ETFs. When it comes to the latter, one of the most popular instruments is the BTC iShares Core MSCI EAFE ETF ( IEFA ). On the surface, the low-cost and high liquidity make the instrument seem attractive. On a second look, while IEFA is doing a decent job tracking its benchmark, it appears that the exclusion of US and Canada has been yielded inferior returns to a total world index. Also, the heavy exposure to Europe may end up being a drag, given that the energy problems are not permanently solved yet. For these reasons, I don't see much benefit of buying IEFA.

IEFA Overview

According to its prospectus , IEFA is designed to track MSCI EAFE IMI Index. The index itself is market capitalization weighted and excludes equities from the USA and Canada.

The passive nature of the ETF, the large AUM and the self-rebalancing characteristic of the Index make the cost structure very lean with an expense ratio of just 0.07%. In addition, the low P/E ratio implies earnings yield of over 7.5%. IAFE pays semi-annual dividends to its shareholders, making it an appealing option for income oriented investors.

Looking at the sector weights of the portfolio, Financials dominate, followed by industrials, while consumer cyclical are fourth. The three sectors have a combined weight of nearly 45%. On the other hand, commodity and energy exposure is quite low at 12.7%. I find this exposure not ideal for an environment with commodity supply challenges, which could in turn hurt industrials and consumer cyclicals.

Looking at the geographical distribution of the holdings, it appears that the index, therefore, the ETF is primarily invested in EU companies. While European equities were suppressed in 2022 on fears of an energy squeeze in the winter, the mild weather may have saved the EU this season. While hoping for a warm winter doesn't seem like a wise energy policy and a permanent solution is not implemented, which will likely take at least several years, Europe will be at the mercy of the weather.

Is excluding USA and Canada beneficial?

The idea behind excluding the US and Canada could be that their economy would be slowing down, therefore equities there will be up for a correction. However, in a globalized world economy, I'm doubtful that European equities perform well if their biggest export partner is struggling.

The best way to assess whether the exclusion of US and Canada has been beneficial to the ETF's performance will be to compare IEFA to a total world index like the Vanguard Total World Stock ETF ( VT ).

A long 10-year historical period demonstrates that the exclusion of US and Canada has led to significant underperformance. While there's no guarantee that this tendency will persist, I think that this is very likely, given the challenges ahead of Europe.

Conclusion

The strategy that the Index, tracked by IEFA seems inferior. The exclusion of US and Canadian equities has resulted in heavy exposure to European equities. However, the latter may be facing challenges as the energy crisis is far from resolved and the war in Ukraine is still raging. Avoiding US equities out of recession fear hardly seems a good choice if the substitute is heavy European exposure, because of the strong ties of their economies. The historical track record indicates, that excluding US and Canada from a diversified ETF leads to underperformance compared to a total world ETF. For these reasons, I see little value of adding IEFA to one's portfolio.

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