The Outdated Index that Won't Give Up

By Gregg Wolper | 11-20-07 | 06:00 AM

An index should closely approximate the universe that investors are choosing from. It's no surprise that the NYSE Composite Index, which tracks the performance of the common stocks listed on the New York Stock Exchange, isn't all that well-known these days. Relatively few investors are limited to the stocks listed on a single exchange, so an index that excludes Microsoft (MSFT), Apple (AAPL), Oracle (ORCL), and every other company listed on Nasdaq doesn't provide a relevant benchmark by which to judge the performance of a manager who can, and does, buy those stocks.

With that in mind, it's odd that the MSCI EAFE Index remains by far the most common benchmark chosen by foreign-focused mutual funds. (MSCI is Morgan Stanley Capital International, and EAFE stands for Europe, Australasia, Far East.) The EAFE index excludes all stocks from emerging markets, as defined by MSCI. That means South Korea, Taiwan, and Israel are out, along with most every other country you'd expect. And because North America is missing from that moniker, Canada joins the United States on the sidelines.

This arrangement made sense years ago. Most mainstream mutual funds were extremely cautious about investing in emerging markets. Those markets were considered much, much riskier than Western Europe, Japan, and Australia, because the political structures in so many of them were unstable, currency crises were fairly common, and their stock markets far behind in terms of automation, trading volume, and regulation. And emerging markets often fell prey to extreme swings in performance.

The index doesn't exclude Canada on those grounds, but at one time many institutional investors did consider that country's economy and stock market to be so closely tied to those of the United States that lumping the two together seemed reasonable. Moreover, Canada had very few stocks that showed up on the radar screens of major international investors.

A New Era Arrives

Much has changed. These days, most portfolio managers running foreign-stock funds invest in emerging markets. The typical manager running a broad international fund has roughly 10% in the markets designated as emerging by MSCI. A manager doesn't have to be aggressive or "have a positive outlook for emerging markets" to reach that level in his or her portfolio.

While the trend toward greater acceptance of emerging-markets investing has been under way for a long time, it really got rolling in the past five to 10 years. There are several reasons. First, the numerous emerging-markets financial and currency crises of the mid- and late 1990s receded from memory. Second, most emerging-markets countries have made vast improvements in their financial structures and government management, with hefty natural-resource revenues helping ease the task. Third, many more companies that previously were smaller or almost unheard of, such as Infosys of India, became global leaders in their fields and could no longer be so easily ignored. Last but not least, the amazingly strong stock market performance in those areas attracted attention.

Meanwhile, the growing prominence of Canadian energy companies and other noteworthy firms such as the maker of the BlackBerry ( Research in Motion (RIMM), plus a very strong currency, all made Canada harder to dismiss as well.

It's Not Gone Yet

With that in mind, a more appropriate index for most broad foreign funds would be one that includes emerging markets and Canada. The MSCI All-Country World ex-US Index is one that fits the bill. Thus, it made sense for Julius Baer International Equity (BJBIX), which has long owned significant emerging-markets stakes, to change its benchmark recently to that index from MSCI EAFE.

Few other funds have followed suit, though. One reason seems to be that funds, and fund boards, simply are reluctant to make changes to fundamental policies. Changing benchmarks isn't something funds have typically done unless they drastically alter their strategy. Moreover, certain well-known benchmarks have become standard. You're a U.S. stock fund, your benchmark is the S&P 500--end of story.

A second reason, less likely to be stated, could be that with the strength of emerging markets, it's easier for an international fund to beat an index that excludes those hot markets. Over the five-year period through Nov. 16, 2007, the MSCI EAFE Index has gained an annualized 21.4%, while the MSCI All-Country World ex-US has posted a 23.8% gain.

In any case, it's worthwhile for investors to recognize that most broad foreign funds still compare themselves with the MSCI EAFE Index. When your fund boasts that it beat its benchmark, see if that benchmark is EAFE. If your fund topped it by owning stocks in emerging markets, most rival funds were doing the same thing. How did it rank against them?

Another realm in which EAFE has maintained its relevance is by serving as the benchmark for index-tracking funds. In fact, its prominence in that arena has been growing. The second-biggest exchange-traded fund, and one of the biggest international funds in mutual fund, ETF, or closed-end format, is iShares MSCI EAFE Index). That fund has $48 billion in its coffers. Does investing in that ETF, or another EAFE-tracker, still make sense? We'll explore that issue in a future Fund Spy column.