MSCI EAFE vs. S&P 500, Nasdaq: How Much Can You Gain or Lose by Investing in MSCI EAFE, EAF/VEA ETF?

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For investors assessing investing/allocating in Europe, Australasia, & Far East, through MSCI’s EAFE, this report utilizes 45 years of data altogether, to answer the following questions:

If you invest in MSCI EAFE (EAF),

1. How much can you gain monthly and yearly, i.e., what is the expected yield on investment?

2. What are the investment risks, i.e., how much can you lose by investing in this index/ETF?

3. How does this index compare to S&P 500 (SPY) and Nasdaq composite index (IXIC) in terms of risk and returns?

MSCI EAFE index is described as “An equity index which captures large and mid-cap representation across 21 Developed Markets countries* around the world, excluding the U.S. and Canada. With 843 constituents (about document).” This report, however, evaluates whether this index is a good opportunity for diversification and capital appreciation. A comparison with the top American indices is also provided. The analysis is based on 45 years of data combined.

The performance evaluated here applies to the ETFs that follow this index, such as iShares MSCI-EAFE-ETF, Vanguard FTSE Developed Markets ETF, SPDR MSCI-EAFE StrategicFactors ETF, etc.

Results of core calculations:

Key factors

The monthly growth rate (geometric mean) of EAF is about -82% lower than SPY (substantially lower), and -89% lower than IXIC; the mean (average return pm), similarly, is also considerably lower than the U.S. indices (-68% lower than SPY, -80% lower than IXIC). Most ETFs tracking this index are based on USD; thus, we can ignore currency fluctuations.

Risk Analysis

To analyze the risk profile of this index, the VaR, sample standard deviation, and variance calculations have been performed.

Value at Risk (VaR), essentially, measures the amount at risk, as per a confidence level; for example, a $10 VaR figure per month, as per a 98% confidence level, per $100 invested would mean that losses, 98% of the time, should be lower than or equal to $10, as per the sample of historical data analyzed.

These calculations are commonly used by banks, financial institutions, and brokers to assess the risks of a position.

The VaR figures for EAF, as per the data:

The monthly VaR percentage value for EAF is 10.5%, and the yearly value is 348.23%. This means that per $1000 invested in this index, say, through an ETF, the investor can lose $100.5 pm, and $348.233 p.a. There is a 98% confidence level attached with these values, and this means that losses, 2% of the time can be higher than these values.

For SPY, the monthly VaR figure, as per the time series analyzed, stands at 8.22% or $82.2 per $1000 pm & 28.5% p.a., meaning $284.6 per $1000 invested annually. For IXIC, the value pm is 9.17% or $91.7 and 31.8% or $317.5 per 1000 invested p.a.

As per the results of the VaR calculations, the value at risk (invested amount at risk) of EAF is higher than the two top American indices examined. Nonetheless, for further nuance, hypothesis testing is conducted below. An F-test has been conducted to determine whether the risk profiles of the indices examined in this report are different (i.e., is the difference statistically significant).

F-Test results:

What does this mean, simplistically?

The hypothesis testing confirms that statistically, the risk profile of EAF is not different from the risk profile of SPY and the risk of profile IXIC. Thus, while an investor may be exposed to a somewhat higher VaR, the risk profile, as assessed by the variance of the subject index, when compared to the U.S. indices, is comparable statistically. For risk-adjusted returns of indices analyzed in this report, i.e., returns offered per unit risk & other diversification concerns, see our report: Which stock indices/index-based ETFs provide the best risk-adjusted returns. See also: Which stock indices/index-based ETFs are the riskiest investments?

How much can you gain (yield on investment) by investing in MSCI EAFE & how does it compare to S&P 500 & Nasdaq (IXIC)?

The yield on investment in EAF, as per the data & 95% mean confidence interval calculation, should fluctuate in the range of 0.99% to -0.49% pm. The yearly average compounded growth rate stands at 1.45%.

Per $1000 invested in this index/ETF, an investor can expect to see monthly returns in the range of $9.9 to $-4.9, 95% of the time, with a 5% probability of returns being lower or higher than the above-stated figures, as per the data.

Investors in S&P 500 and Nasdaq (IXIC), on the other hand, can expect the following returns:

Nasdaq: per $1000 invested, returns, as per 95% confidence interval, should be in the range of $19.4 to $4.5, with returns being better or worse than these figures 5% of the time.

SPY: per $1000 invested, returns, as per 95% confidence interval, should be in the range of $14.4 to $1.3, with returns being better or worse than these figures 5% of the time.

For further nuance, hypothesis testing has been conducted. A pooled variance test is conducted to test whether the returns of the three are different with any statistical significance.

Pooled variance test results:

What does this mean, simplistically?

Pooled variance test confirms that the returns of EAF are statistically comparable to the returns to the returns of SPY & IXIC. Nonetheless, overall, the subject index’s performance does seem less attractive than the two American indices used for the comparison, practically.

A discussion of all factors combined

While statistically, we cannot favor the U.S. indices, practically, the performance of EAF cannot be considered as impressive or on par with the two American ones used for comparison here.

The subject index/ETF has not performed highly favorably and, even though the deficiencies in the performance aren’t statistically significant, the U.S. indices’ performance does stand out as superior.

For investors interested in achieving diversity of names in the portfolio, on the face of it, this ETF/index does appear as well-diversified with companies from multiple jurisdictions included.

However, it should be understood that it has a high correlation of returns with American indices (included in the summary values table), and the top 10 constituents in this index, such as Nestle, Unilever, Astra Zeneca, Toyota motors, etc., have significant reliance on North American.

This means that any significant economic fluctuations in America would significantly impact the top constituents of this index, and thus, if one is considering this ETF/Index as a vehicle for reducing exposure risk to North America, they should understand that due to the factors explained above, diversification objective, through a substantial allocation in the subject, would not be effectively accomplished.

Those concerned about the overvaluation (high prices compared to intrinsic value) of top U.S. stocks may also be interested in adding foreign names to their portfolio. Nonetheless, it should be understood that if a stock market crash occurs in America, due to the high correlation of returns of this index/ETF with SPY & Nasdaq (IXIC), we should expect the prices of constituents in this index, overall, to also be impacted severely.

For example, the correlation of the subject with SPY stands at about 0.9; this means that if SPY crashes by, say 35%, as per the data, EAF should fall by about 31% as well, regardless of some names not being overvalued in it (see report on the average decline in the stock market crash). See also: Why do all financial assets correlatively fall in a market crash

For long-term capital appreciation, it should be noted that this index lacks growth stocks, especially in the tech sector. While it is claimed that it has about 9% exposure to I.T., analysis of all constituents reveals a lack of names that may restart the creative destruction process in the industry, or start it (see report for understanding the creative destruction process).

Broadly, thus, this ETF/index is low-volatility, established names, heavy. Mature companies in many areas, nonetheless, are experiencing strong challenges, and while they may still be a good stable investment for the mid-term horizon, long-term, nevertheless, due to the emergence of new distribution, production, & operational strategies, they would face challenges that impact their bottom-line.

Lastly, it would be very difficult to justify an allocation of more than 5% of the portfolio in the subject. As on the face of it, it may seem as an allocation in the subject would provide advantages of diversification, nonetheless, as explained earlier, this isn’t entirely accurate.

For those desiring to gain diversification/exposure of different business models, similarly, may not find this index as ideal, as it is heavily allocated in low-volatility stable names; for gaining exposure to a wide variety of business models, arguably, exposure to small-caps and micro-caps would be a more appropriate strategy (for in-depth analysis of small-caps, see our report; for in-depth analysis of micro-caps, see our report). See also: How long does a market bubble last on average?

For a consultation on this topic, do get in touch with us!