Should you be looking towards EAFE large-cap stocks?

Europe, Australasia and the Far East (EAFE, Financial)

Large-cap blend stocks are common in the international arena. These types of stocks are similar in many respects to the S&P 500 Index in the U.S. The index which denominates these global large-cap stocks is known as the EAFE – otherwise known as Europe, Australasia and the Far East. This index represents the finest companies in the world – outside of the U.S. Inside the U.S. the S&P 500 index holds the top companies.

When measuring these indexes side-by-side it is clear that there is a large degree of correlation between them. During the course of 2014, the Europe, Australasia and the Far East (EAFE, Financial) shed 5.7% but the S&P 500 index recorded a 13.5% gain. In 2015, the performance of the EAFE has exceeded that of the S&P 500 index. Consider for a moment that the S&P 500 only gained 2% while the EAFE managed an 8% gain.

The Performance of EAFE vs S&P 500

Investors looking to evaluate the profitability potential of the EAFE and the S&P 500 will be heartened to know that both have produced strong returns since 1970. In fact, for the 45-year period from 1970 – 2014, the S&P 500 index generated compound growth of 10.5% while the EAFE generated compound growth of 9.7%. Based on those rates, an initial investment of $100 in the S&P 500 index would have generated $8,845 while the equivalent $100 investment in the EAFE would have generated $6,405. By annually rebalancing these indexes, a return of 10.3% could be produced.

When it comes to evaluating the best 1-year gain for the EAFE, the year 1986 comes to mind. It was at that stage that it gained 69.9%. For the S&P 500 index, the best 1-year gain was 1995 when it generated a 37.6% gain. Conversely, when the global financial crisis hit in 2008, both indexes fared poorly with the S&P 500 dropping 37% and the EAFE losing 43.1%. For investment purposes however, the goal is to invest in periods of 15 years. While the EAFE has generated a compound return of 11% from 1970-2014, the S&P 500 index has generated an 11.8% average return.

Should You Invest in EAFE?

As it stands, the numbers do not present investors with a compelling-enough case to take the plunge. The EAFE runs neck-and-neck with the S&P 500 for the most part, often falling a little behind in terms of performance figures. Sometimes, sage advice from investment gurus is to avoid ploughing funds into EAFE altogether. Investors with allocations in other global asset classes often opt out of investing in EAFE. Sage advice for investors is to allocate a portion of your investment funds into EAFE and the S&P 500 – at least 10% to 20%. The ideal combination is a mix of large-cap stocks and the S&P 500.

Since these types of asset categories represent the best-performing companies in the world, investing in them makes sense. In addition to having the best management teams running these companies, they also offer terrific prospects and a great range of products too. This makes these stocks highly valuable and relatively ‘expensive.’ But it should be remembered that these stocks will not always perform best over the long-term. Where they do well is in economic downturns. When the markets crash or correct, blue chip stocks tend to hold their value far better than other stocks. This is especially true when we consider the performance of emerging market companies and smaller companies.

Several Vanguard funds including the VTMGX (EAFE, Financial) and the VFINX (S&P 500 Index) are affordable and well worth considering. It is a relatively easy undertaking to invest in these large-cap funds. The developed markets fund comprises 1,367 companies with an average size of $31.5 billion. However, the other fund – the S&P 500 Index Fund has 504 companies with an average valuation of $73.8 billion. Vanguard Developed Markets Index Fund has shown steady growth since mid-2012 when the price was $9.25 and now trades at $13.31. The Year To Date (YTD) return is 10.84% and the net assets are $6.8 billion. The company’s yield is 2.89% and the expense ratio is 0.09%.

By contrast, the VFINX fund (Vanguard 500 Index Fund Investor Class) has shown strong growth since March 2009 when it traded at $63.26. The upward trajectory has continued unabated and the price now stands at $192.52. The Year to Date return is 2.91%. The fund’s yield (ttm) is 1.84% and the expense ratio is 0.17%. Vanguard 500 Index Inv (VFINX) net assets under control are $206.62 billion.

Investing in Small-Cap Stocks

There is a great deal of uncertainty about whether or not small-cap stocks are a wise investment alternative. High volatility and economic uncertainty make it unwise to invest in small-cap stocks. Presently, small-cap stocks have been outperforming large-cap stocks, but over the long term it’s uncertain how this will all play out. Performance for 2015 has been solid for the year, but it’s the PE ratios that make for interesting reading.

In mid-April 2015, the Russell 2000 index traded at a PE of 18.9, but if earnings growth shoots above 7%, the measure will exceed 19. Small cap stocks have a market cap of $300m - $2b. Plus, they are highly vulnerable to the impact of interest-rate hikes in the future. For the Year to Date (YTD), the small-cap index is hovering around 3.5% while the S&P 500 has gained a smidgeon over 2%. Even Banc De Binary market analysts point to the impressive gains in small-cap stocks in 2015.

Since the 1970s, small-cap stocks have traded on average at 7% premium compared to large-cap stocks. In terms of valuation, there are several factors to consider such as growth forecast, interest-rate and inflation. As it stands, small-cap stocks are enjoying a purple patch with low interest rates, low inflation and strong growth prospects. All things considered, small-cap stocks are definitely a worthwhile consideration in your financial portfolio.