John Spence

Index Spotlight: Broader MSCI EAFE Should Raise Bar for Active Managers

The benefits of using index funds to invest in the U.S. stock market have been well documented, but some make the argument that indexing international markets is a sure way to underperform. The smoking gun in the international active vs. passive debate is the large number of active managers that outperform the traditional yardstick for international equities: the MSCI EAFE index.

For the 15-year period ended May 31, 2002, 89% of funds in Morningstar's foreign stock fund category beat it. This is a small data set because there just aren't a lot of foreign funds that have been around that long - only 27. For the 10-year period, there are 77 funds and 62% of them beat the MSCI EAFE index.

"The MSCI EAFE's return has historically been an easy hurdle to clear," said Morningstar analyst Peter Di Teresa.

Although these numbers give the impression that the MSCI EAFE (Europe, Australasia, Far East) is a punching dummy for active managers, the comparison needs to be taken in context. First, the data doesn't reflect survivorship bias - poor-performing active funds can be taken out back and shot or merged out of existence.

Second and more importantly, judging the success of an international manager against the MSCI EAFE can be misleading, despite the index's traditional widespread acceptance and use. For example, Morningstar's definition of its foreign stock category is "an international fund having no more than 10% of stocks invested in the United States." That's a fairly broad mandate, and group evaluations against the MSCI EAFE may not result in apples-to-apples comparisons.

By the same token, index fund advocates have also been guilty of unfair performance evaluations in their attacks on active managers. For example, in the late 1990s indexers loved to point to the small percentage of all equity active funds that outperformed the S&P 500. However, the economy was experiencing an unprecedented bull market for large-cap growth stocks, and a few names came to dominate the index and fuel eye-popping annual returns. It's unfair to lump all active managers together and compare them to a hot-performing asset class - fund managers should be judged against the relevant benchmark. The fact that a small-cap manager is lagging the S&P 500 says nothing about his or her stock-picking skills; instead the S&P SmallCap 600 or Russell 2000 should be used. Consider the following excerpt from a recent Journal of Indexes article by Vanguard index fund manager Gus Sauter, who also managers some of Vanguard's active funds:

"A widespread misconception is that indexing works in large caps, but not in sectors such as small caps. At times, this conclusion appears to be supported by the data. But the data's real lesson is that we're measuring managers with the wrong yardsticks. With better benchmarks, outperforming - or underperforming - an index would no longer be a matter of holding stocks from a different universe. Performance would reflect the success of a manager's stock selections within the appropriate universe. Although it's unlikely that large numbers of active managers could boast of index-beating performance, even over short periods, these better indexes could in fact be a boon to talented active managers. Their relative success could be attributed to skill, not dismissed as an artifact of faulty benchmark construction."

Comparing an active manager's performance against a benchmark is only useful if the index represents the entire opportunity set available. In this scenario, the way a manager beats (or loses to) the appropriate index is to not look like it by underweighting or overweighting certain stocks or sectors relative to the index. For example, an active manager correctly benchmarked against the MSCI EAFE had great success against the index in the 1990s by underweighting a struggling Japanese economy. However, it should be noted that many Western fund managers also underweighted Japan in the 1980s, which led to underperformance as the Japanese economy zoomed ahead.

Country bets aside, the MSCI EAFE should be a tougher hurdle to clear for active managers because the index is beefing up its coverage. At the end of May 2002, the MSCI EAFE expanded its coverage in each country to 85% of float-adjusted market capitalization, up from the previous 60% of total market capitalization. What this means is that active managers will have a smaller forest in which to hunt outside the index for companies that may outperform.

"As the EAFE Index grows to 85% of the investable universe, the variability of managers' returns around the index will decrease," wrote Barclays Global Investors investment strategists Binu George and Andy Olma in a recent brief.

The bottom line is that for many investors looking to diversify outside the U.S., international index funds still offer the same primary benefits as their domestic counterparts: lower expenses, tax efficiency, and style consistency. As Nobel Laureate William Sharpe states in his classic article The Arithmetic of Active Management, after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar. However, this is only true if the index represents the entire opportunity set available to active managers, or at least as much of it as possible. Therefore, the expanded coverage of the MSCI EAFE index should be good news for passive investors.