This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief investment strategist of Omaha, Nebraska-based CLS Investments.
International markets are finally starting to realize the potential for outperformance that has been there for years. So far this year, the MSCI ACWI ex U.S. is up 7.63 percent in dollar terms, putting it about 5 percentage points ahead of the S&P 500 Index.
For some investors who have struggled to hold international stocks through periods of underperformance, just seeing the broad index outperform is enough. For the more adventuresome, there are opportunities for outperformance in diversified-factor ETFs that could be used for a portion of their portfolios.
Based on changes in fundamentals and policies, international value stocks and companies buying back large portions of their shares represent attractive factors to emphasize in international portfolios.
To access those two phenomena in ETFs, there’s the iShares MSCI EAFE Value ETF (EFV | B-94) that represents international value stocks well, and the PowerShares International BuyBack Achievers Portfolio (IPKW | D-42) is the only ETF focused on international buybacks.
Quantitative easing (QE) programs in Europe and Japan are the big factors supporting these two ETFs. Because the programs achieved full force much later than the U.S.’ QE program, the U.S. program provides some direction on how international stocks should benefit.
Europe’s QE program has pushed the yields of many sovereign bonds below zero percent. Investors have pushed the euro lower in response to a lengthy period of expected low rates. The cheaper currency and encouragement of risk-taking will likely support the nascent European economic recovery.
Japan’s economy shows similar potential. This article examines three expected outcomes of QE. The first two outcomes support emphasizing value stocks, and the third focuses on buybacks.
Growth stocks often outperform value when their secular growth stories provide the only source of meaningful growth for companies. In periods when growth outperforms, value stocks are hampered by low growth in the overall economy, which constrains company sales. Over the last year, this trend has pushed growth stocks ahead of value stocks.
For example, the iShares MSCI EAFE Growth ETF (EFG | B-93) is up more than 5.90 percent over the last year, while EAFE Value is up less than 1 percent. Based on expectations for higher economic growth in Europe, some of this performance advantage should reverse.
Attractive yields provide a second reason to favor international value stocks. International value, based on Morningstar estimates, is expected to yield 4.03 percent. This compares favorably to 2.24 percent for EAFE Growth. Interestingly, the yield on EFV—the iShares international value-focused fund—is comparable or better than some dividend-focused U.S. ETFs.
For instance, the Vanguard High Dividend Yield ETF (VYM | A-95) is expected to yield 3.48 percent. In the U.S., high-yielding stocks outpaced the Russell 3000 over the last five years. As European investors react to low yields on bonds, the high yields available in value should be attractive. U.S investors may also find the higher yields abroad too luring to pass up.
Share buybacks are another way for corporations to return cash to shareholders.
As rates dropped from the U.S.’ QE program, corporations used cash flow and debt to repurchase shares, driving up earnings-per-share by shrinking the denominator rather than growing earnings. International firms now have the same opportunity, including those in countries such as Italy and Spain, where rates have dropped sharply and valuations are cheap.
QE programs should also be viewed in the larger context of economic reform.
For instance, in Japan, Abenomics relies on three arrows: monetary stimulus, fiscal stimulus, and reform, according to various media reports. Meanwhile, some look for reform to come from changes to government labor laws. Another important source of reform can be corporate reform. International developed countries sport price-to-book ratios well below those in the U.S.
The main reason for those lower international price-to-book ratios is U.S. corporations are more effective at turning assets into profits. Fiscal discipline inside companies should mean a greater focus on returning money to shareholders rather than engaging in corporate projects designed to maintain the size of the organization.
IPKW provides an opportunity for U.S. investors to purchase a group of companies that has shrunk its share count by at least 5 percent in the previous fiscal year.
Working off the hypothesis that international markets are traveling a similar path to the U.S., the performance of the domestic-focused PowerShares BuyBack Achievers Portfolio (PKW | B-99) should prove heartwarming. PKW returned more than 18 percent annualized over the last five years, relative to the Russell 3000 Index gaining slightly more than 14 percent.
EFV is a large fund with nearly $3 billion in assets, and it averages more than 50,000 shares traded each day, according to iShares. IPKW’s asset base is much smaller than EFV; it only has $25 million, and is more concentrated than EFV. The buyback strategy has proven popular in the domestic market. PKW now has more than $3 billion in assets. Three years ago, PKW had only $133 million.
CLS uses factors to emphasize stocks of a particular type, while remaining diversified. EFV and IPKW are worth a look, as ETFs keep investors diversified while giving portfolios a better chance to add value.
At the time this article was written, the author’s firm owned shares of EFV in client portfolios. CLS Investments is an Omaha, Nebraska.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS' Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.