ETF Trends
ETF Trends

A bullish investor consensus for European equities appears to be building.  More and more, we are hearing and reading that European equities are attractive and undervalued.  It may be the right time for greater exposure to developed international equities, and Europe might be the right place for investors to focus.

However, why stop there?  Why stop at the regional level?  Why buy every developed county in Europe when not every country in Europe is attractive and undervalued?  Furthermore, why overweight the largest countries and companies in Europe if they are not the most attractive or undervalued?

The Smart Beta Approach

European equities, in aggregate, do appear attractive and can be accessed via ETFs like VGK (Vanguard) and IEV (iShares).  These ETFs approximate the FTSE Developed Europe Index.  This index provides market capitalization weighted exposure to developed Europe.  The top ten country allocations in VGK are 1) United Kingdom (33.1%), 2) France (14.4%), 3) Germany (14.0%), 4) Switzerland (13.5%), 5) Spain (5.0%), 6) Sweden (4.8%), 7) Netherlands (4.6%), 8) Italy (3.4%), 9) Denmark (1.9%), 10) Belgium (1.8). *

Cap-weighted equity index funds tend to overweight overvalued securities and underweight undervalued ones, creating a 2% return drag in developed markets and more in less efficient ones. Smart beta strategies retain the benefits of traditional capitalization-weighted indices, such as broad market exposure, diversification, liquidity, transparency, and low cost access to markets. At the same time, they offer the opportunity to achieve superior performance over the cap-weighted benchmark. *

Perhaps a non-market capitalization weighted “smart beta” approach to Europe is better suited for this European investment opportunity.  In the case of VGK and IEV, investors are gaining exposure to the largest companies in Europe and simultaneously gaining exposure to the countries with the largest market capitalizations.  So, with 75% of VGK allocated to only 4 countries, an investor must ask the question: Are the biggest companies and biggest countries the most attractive segment of the Europe?

A Deeper Dive

A balanced multi-factor review of the countries in Europe reveals that France (a 14.4% weight in VGK) is not as attractive as Spain, and Switzerland (a 13.5% weight in VGK) is not as attractive as Sweden.  Through an analysis of country level momentum, valuations, risks, and fundamentals we find that a market capitalization weighted approach to European equities may be sub-optimal.  Historically, larger allocations to countries with relatively positive momentum, low valuations, and strong fundamentals benefits investors over a full market cycle. *

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