MSCI EAFE: A stock market that time, and the internet, forgot

• One of the best ways to invest in developed markets outside the US is MSCI EAFE Index ETFs.
• The EAFE technology weighting should ring alarm bells.
• At only 6% tech, it's a serious laggard compared to tech weightings of 25% in the S&P 500 and 30% in MSCI Emerging Markets.

Vanni Bassetti | Getty Images

Remember life before the internet? No smartphones, no video streaming, no social media, no online shopping …

If you are nostalgic for that world, just check out the MSCI EAFE Index.

One of the oldest non-U.S. equity market measurements around, it covers developed economies in Europe, Asia and the Far East. The fourth-largest ETF in the United States (EFA, with $81 billion) tracks the EAFE, as do many other passive investment products.

Country weightings as of mid-November were as follows: Japan, 23 percent; United Kingdom, 18 percent; France, 11 percent; Germany, 10 percent; Switzerland, 8 percent; Australia, 7 percent; Spain, 3 percent and all else 20 percent.

The reason we think of the EAFE Index as "pre-internet" is not, however, because of the countries represented; rather, it is because the weighting to technology is just 6 percent. Compare that to the S&P 500 with a 25 percent weighting. Or the MSCI Emerging Markets Index at 30 percent. Tech stocks are as important to the EAFE as energy stocks are to the S&P 500. Which is to say, "not very much."

The index that time forgot

Why such a disconnect between the EAFE weighting to tech and that for U.S. or emerging market equities? And how has this distinctly old-school index managed to beat the S&P 500 this year?

On the first question, a few points:

The EAFE countries don't have as many super-cap tech companies as the United States or emerging markets. There is only one — SAP — in the top 20 holdings.

For the S&P, there are six in the top 20: AAPL, FB, MSFT, GOOG/L, AMZN and INTC.

In emerging markets, there are eight in the top 20: Tencent, Samsung, Alibaba, Taiwan Semi, Baidu, China Mobile, Hon Hai and Hynix.

The unavoidable conclusion: Western Europe and Japan are far behind the United States and China/Taiwan/Korea in building dominant global tech companies.

Can they catch up? Only time will tell, but these regions clearly have a long way to go.

• The EAFE Index has a range of heavyweight (but non-tech) industries in the mix: Financials (21 percent weighting), industrials (14 percent), consumer discretionary (12 percent), staples (11 percent) and health care (10 percent).
• The largest companies in the EAFE Index are distinctly old-school as well. Nestlé has the largest influence here, with a 1.8 percent weighting. Following it are HSBC (1.3 percent), Novartis (1.3 percent), Roche (1.2 percent) and Toyota (1.1 percent).

As a reminder, the top names in the S&P 500 are Apple (4.0 percent), Microsoft (2.9 percent), Google (combined 2.8 percent), Amazon (2.0 percent) and Facebook (1.9 percent). Yes, all tech.

For the MSCI Emerging Markets Index, the top holdings are Tencent (5.4%), Samsung (4.7%), Alibaba (4.0%), Taiwan Semi (3.8%) and Naspers (2.2%). Again, all tech or (in the case of the last name) tech-related.

So how has the "Index that Time Forgot" managed to beat the S&P 500 this year (+20.5 percent versus 16.1 percent)? The answer comes down to four points:

• The EAFE Index has been a dramatic laggard over the last five years versus the S&P 500, so there is some catch-up effect at work.
• The large weighting to Japanese equities has helped the EAFE index in dollar terms, with YTD returns of 22 percent for that country's equity market.
• While the U.K.'s equity market has struggled due to Brexit worries, both French equities (up 26 percent) and German stocks (25 percent) have picked up the slack.
• Valuations also look better for EAFE stocks than their developed country counterparts in the United States, at 15x forward earnings vs. 18x.

With these breadcrumbs in place, it is easy enough to see where they lead: Ultra-low interest rates in Japan and Europe, created by central bank bond buying. Ten-year Japanese government bonds yield just 4 to 5 basis points. The same paper in France and Germany: 67 basis points and 35 basis points, respectively.

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It is primarily that liquidity/artificially low yields, albeit coupled with some earnings growth and cheaper valuations, has pushed the EAFE Index higher for the year than the S&P 500. Reasonable investors may differ on whether the tech-dominated S&P 500 or MSCI Emerging Markets index merit their current multiples, or what disruptions the companies domiciled in these regions may bring. But these are not issues for the EAFE Index. And that's a real problem.

While the EAFE Index has done well this year, we can't help but think the ingredients for this rally are approaching their sell-by date. Central bank bond-buying can — and has — lowered interest rates and pushed capital into stocks. Fair enough, but that cannot go on forever.

What central banks cannot do is spark the innovation needed to create lasting earnings growth in a world dominated by technological disruption. On that count, the EAFE Index is woefully underweight.

— By Nick Colas, co-founder of DataTrek Research