The iShares MSCI Europe ETF is suitable for use as either a core portfolio building block or a tactical tool. It can be used as a core portfolio building block for investors seeking exposure to equity markets across developed Europe. As for its potential uses as a tactical tool, more aggressive investors could use this ETF to overweight European equities, or it can be shorted to bet against the performance of the underlying equities to hedge an existing position.The inclusion of Switzerland and the UK within the MSCI Europe index makes this ETF a somewhat more diversified option than a strict Eurozone equity benchmark. Still, at 0.95, the 3-year correlation between the MSCI Europe index and the MSCI EMU index has been very high. As such, there is little diversification benefit to using this fund in tandem with other vehicles tracking broad developed Europe benchmarks. Investors in the UK or Switzerland who already have exposure to their domestic equity market, perhaps through a FTSE 100- or SMI-following ETF, should take care not to unintentionally overweight their domestic exposure in their portfolio by adding this ETF.
The economic outlook for Europe remains rather gloomy. The Ifo-Index in Germany, a business confidence indicator, fell to 104.4 in April; down from 106.7 a month earlier and below expectations for a slight retreat to 106.2. In addition, private-sector activity in the Eurozone dropped again in April, while business activities in Germany fell the first time since November. The composite PMI in the Eurozone remained unchanged at 46.5 while pointing towards a further drop in manufacturing output as new orders declined for a 21 straight months to month. Germany’s PMI dropped below the threshold of 50; reaching 48.8, while France PMI eased slightly to 44.2.
The sharp drop in business confidence in the once resilient economy of Germany, coupled with weak economic data in the rest of the monetary union and the absence of inflationary pressures, led the European Central Bank to cut interest rates to a new historical low of 0.50% from 0.75% at its May policy meeting, while leaving the door open for further monetary stimulus should the situation deteriorate.
The latest credit conditions survey from the ECB reported a drop in credit demand from companies and households, underscoring the loss of consumer confidence, despite cheap access to funding. Eurozone GDP has contracted for five consecutive quarters to end 2012, while more recent data suggest a contraction in the first three months of the year as well.
On the back of continuously weak data, international bodies such as the IMF have raised concerns as to whether the austerity measures implemented by many European countries are still the best approach to solve the crisis. The same message has been echoed by European Commission President José Manuel Barroso. Though not abandoning the fiscal austerity principle, the EU has already given Eurozone peripheral countries extra years to achieve their budget deficit elimination programmes, which should thus slow down the pace of cuts and, hopefully, aid growth. .
Accelerating cost cutting by European companies on the back of a gloomy economic outlook should continue to weigh on consumer sentiment as companies lay off workers and close plants. Unemployment in France and Spain is at historical highs, while Germany’s new-car registrations have dropped by 12% y/y.
Outside the Eurozone, the UK avoided slipping into its third recession since the financial crisis by posting a 0.3% q/q expansion in GDP in Q1-13. Despite this relief, Finance Minister George Osborne remains under pressure to boost economic growth via spending and to relax austerity targets; particularly after Fitch Rating followed Moody’s in stripping the country of its triple A-rating. The IMF has suggested to slow the pace of spending cuts given the weak economy and lowered its UK growth forecast for 2013 from 1% down to 0.7%, while lowering expectations for 2014 from 1.8% to 1.5%.
Going forward, weak economic indicators for Northern Europe, like Germany, raise concerns that the policy response to the long-running sovereign debt-crisis is starting to also affect these countries. Overall, market consensus points towards a weak summer for the European economy. However, looser austerity measures and a longer time-frame to deliver budget consolidation measures could support an economic recovery.
The MSCI Europe Index includes approximately 85% of the equity market capitalisation of 16 countries across developed Europe. Components must meet minimum criteria for liquidity, as well as foreign ownership restrictions. The securities are weighed by free-float adjusted market capitalisation. Because closely held firms will have a smaller piece of their aggregate market capitalisation floated on public exchanges, the free float adjustment serves to ensure the underlying liquidity of the holdings is superior relative to a pure market capitalisation weighting. The index is reviewed four times a year. As of this writing, there are 436 stocks in the index. The index is not top-heavy, with about 20% of its total value comprised by the top ten constituents. The index has fairly limited sector concentration. The financial sector, the most represented sector in the index, represents 21% of the index’s value. With a 32% weighting, the UK is the most represented nation in the index and the only one to exceed a 15% weighting.
This ETF uses physical replication techniques to track the performance of the MSCI Europe Index. The fund holds all the constituents of the index.
iShares may engage in securities lending within this fund to generate additional revenues for the fund. The lending revenues generated from this activity are split 60/40 between the fund and the lending agent BlackRock, whereby BlackRock covers the costs involved. To protect the fund from a borrower’s default, BlackRock takes collateral greater than the loan value. Collateral levels vary from 102.5% to 112% of the value of securities on loan, depending on the assets provided by the borrower as collateral. Additional counterparty risk mitigation measures include borrower default indemnification. Specifically, BlackRock commits to replace the securities that a borrower would fail to return. The indemnification arrangement is subject to changes, and in some cases without notice. Finally, BackRock limits the amount of assets that can be lent out by this ETF at 50%.Cash received as dividends from the underlying stocks is held in the fund’s income account until it is distributed to fund holders. Distributions are made on a quarterly basis. This dividend treatment can potentially create a drag on returns in upward trending markets as dividends are not reinvested into the fund. In practice this cuts both ways. It could also result in outperformance if the benchmark falls in the interim period.
The iShares MSCI Europe charges a total expense ratio (TER) of 0.35%. This lies in upper of the range of ETFs tracking pan-European indices. Other potential costs associated with holding this fund which are not included in the TER include rebalancing costs, bid-ask spreads and brokerage fees.
There are several ETFs offering European equity exposure, tracking different indices. The largest alternative in terms of total asset under management is the iShares STOXX Europe 600 (DE) ETF, which uses physical replication and levies a TER of 0.20%. The underlying index is very similar to the MSCI Europe Index in terms of sector and country exposure. However, the MSCI Europe Index has slightly fewer constituents.
Investors look for a pure eurozone exposure can make use of the Lyxor ETF EURO STOXX 50. This ETF uses synthetic replication and levies a TER of 0.25%.