Getting Your Developed Market ETFs Right

Year-to-date ETF flows show a lot of interest, but perhaps in the wrong funds.

With only two months left to go in the year, I’m always curious where folks are placing their bets. I was frankly surprised to see that once you dig below the headline ETF flows numbers for October, the No. 1 overall segment for inflows was non-U.S. developed markets. Overall, year-to-date, this set of 40 funds has pulled in $14.2 billion—a sizable chunk of the overall 2014 ETF flows of $157 billion.

Why is that a surprise? First of all, the conventional wisdom of the past few years has been that the correlation between the U.S. market and the rest of the developed world was just too high to justify the extra risk.

And indeed, for most of 2010-2012, that was indeed the case. The last 18 months, however, has seen that correlation break down. Here’s the trailing monthly correlations for the MSCI US index, versus the EAFE index:

The problem, of course, is that most of this lowering in average correlation has been because the U.S. market has been on fire, and Europe hasn’t been keeping up. Still, I suspect that this hunt for uncorrelated equities is what’s driven some pretty impressive flows so far this year:

I tease a few things out of this.

First, I find it interesting that the Vanguard FTSE Developed Markets ETF (VEA | A-92) is leading the list. Vanguard’s been having a heck of a year, with all sorts of core-exposure ETFs experiencing inflows. VEA changed its index from the MSCI EAFE index last year, but the differences are essentially cosmetic.

VEA is not the cheapest fund in the space. It has an expense ratio of 9 basis points, versus the 8 bps charged by the Schwab International Equity (SCHF | A-95). However, on a real-world basis, VEA is better than free. VEA's median tracking difference—that is, your real-world experience on an average year—is positive 16 basis points. That means you get paid 16 basis points to own it. SCHF, despite being "cheaper" actually tracks worse—its median tracking difference is negative 13 basis points—worse than you'd expect.

What I don’t understand going on here is the rather massive implied bet being made against the dollar with these two ETFs. On average, these ETFs are making something like a 21 percent bet on the pound, a 21 percent bet on the yen, with substantial euro, Aussie dollar and Swiss franc exposure on the side.

That has really, really cost investors in developed markets this year. Consider this chart of the iShares MSCI EAFE (EFA | A-92) versus its otherwise-identical hedged counterpart, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-64), as well as SCHF and VEA.

Instead of losing 2.3 percent of their money, DBEF investors have been able to hedge out the effects of the strong dollar and gained 3.5 percent on the year.

It’s worth noting that this situation was much less clear this summer, but I do wonder whether all of the money flowing into the developed-ex-U.S. funds has recognized the conscious bet they’ve made against the dollar—an increasingly bad-looking bet, given the radical liquidity being dumped into the Japanese economy in particular.

Last, I’d be remiss if I didn’t point out the surprising performance leader in this pack, the iShares MSCI EAFE Minimum Volatility ETF (EFAV | A-46). EFAV takes an extremely concentrated set of positions—just 200 stocks—out of the entire developed ex-U.S. universe, selecting for low volatility.

The net effect keeps market-cap exposures relatively in line with EAFE, but weighs the most stable economies—like England and Switzerland—more heavily, and loads up on more defensive sectors like non-cyclical consumer stocks and health care. Just that skew alone has given it a nearly 9 percent lead over the regular EAFE funds.

Imagine if you could hedge the dollar out of that exposure. Then you’d have been cooking with gas.

Until that time, smart investors should be going into their core international exposure with a clear eye toward their immediate concerns. If you think defense is still going to be the best offense, EFAV will likely continue its outperformance.

If you think the dollar keeps on trucking, DBEF may be your better bet. And if you’re truly sticking money in the long-term mattress, where the currency and market cycles are likely to even out, then the herd going into VEA probably made the right call.

At the time this article was written, the author held a position in SCHF. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.