Eafe index: Meaning, Criticisms & Real-World Uses

What Is EAFE Index?

The EAFE Index, formally known as the MSCI EAFE Index, is a prominent stock market index designed to measure the equity market performance of developed markets outside of the United States and Canada. Launched by Morgan Stanley Capital International (MSCI), the EAFE acronym stands for Europe, Australasia, and the Far East. As a key component of global investment benchmarks, the EAFE Index is widely used by asset managers and institutional investors as a standard for assessing the performance of international portfolios. This index captures large and mid-capitalization representation across 21 developed countries in these regions, covering approximately 85% of the free float-adjusted market capitalization in each country²⁸.

History and Origin

The MSCI EAFE Index has a long history, with its calculation dating back to December 31, 1969, making it one of the oldest truly international stock indices²⁷. It was officially launched by Morgan Stanley Capital International (MSCI) in 1986²⁶. The creation of the EAFE Index provided a comprehensive and transparent benchmark for investors seeking exposure to international equities outside of North America. Over the decades, the index has evolved, with adjustments to its constituent countries. For example, Israel was added to the EAFE Index in May 2010 when MSCI reclassified it from an emerging market to a developed market. This continuous refinement ensures the index remains relevant and representative of its target markets.

Key Takeaways

The EAFE Index tracks large and mid-cap stocks in 21 developed countries across Europe, Australasia (Australia and New Zealand), and the Far East.
It serves as a widely recognized benchmark for international equity performance, particularly for institutional investors and mutual funds based in North America.
The EAFE Index uses a market capitalization-weighted methodology, meaning larger companies have a greater influence on the index's performance²⁴, ²⁵.
It provides a means for portfolio diversification for investors looking beyond U.S. and Canadian equities, offering exposure to a broad range of companies and sectors²³.
While offering international exposure, the EAFE Index excludes major economies classified as emerging markets, such as China, India, Brazil, and Russia²².

Formula and Calculation

The EAFE Index is constructed using a market capitalization-weighted methodology. This means that the weight of each security within the index is determined by its total market capitalization relative to the aggregate market capitalization of all securities in the index²⁰, ²¹.

The market capitalization of a company is calculated as:

\text{Market Capitalization} = \text{Shares Outstanding} \times \text{Stock Price}

The weight ((W_i)) of an individual stock ((i)) in the index is calculated as:

W_i = \frac{\text{Market Cap}_i}{\sum_{j=1}^{N} \text{Market Cap}_j}

Where:

(\text{Market Cap}_i) = Market capitalization of stock (i)
(\sum_{j=1}^{N} \text{Market Cap}_j) = Sum of market capitalizations of all (N) stocks in the index.

The index value itself is typically calculated using a divisor method, where the aggregate free float-adjusted market capitalization of all constituent companies is divided by a divisor. The divisor is adjusted for corporate actions such as stock splits or new issuances to maintain index continuity.

Interpreting the EAFE Index

Interpreting the EAFE Index involves understanding its purpose as a performance gauge for developed markets outside North America. When evaluating the EAFE Index, investors and analysts typically look at its total return, price performance, and comparisons against other indices or investment portfolios. A rising EAFE Index indicates positive performance in the underlying European, Australasian, and Far Eastern equity markets, while a decline suggests weakness.

For asset managers, the EAFE Index serves as a critical benchmark against which they measure the success of their international equity funds¹⁹. If a fund tracking or investing in these regions consistently outperforms the EAFE Index, it suggests the manager is adding value beyond market returns. Conversely, underperformance may indicate issues with the fund's investment strategy or security selection. Investors can also use the EAFE Index to gauge the health and trends of the specific global regions it covers.

Hypothetical Example

Imagine an investment firm, Global Horizon Investments, manages a "Developed International Equity Fund" designed to provide clients with exposure to markets outside the U.S. and Canada. The fund's primary benchmark is the EAFE Index.

At the beginning of the year, the EAFE Index had a value of 2,500 points. Over the course of the year, the markets in Europe, Australasia, and the Far East experienced a strong rally. Global Horizon's fund, through its holdings of equity securities from these regions, performed well.

By the end of the year, the EAFE Index had risen to 2,750 points, representing a 10% gain. Global Horizon's fund, after all fees and expenses, achieved a total return of 11.5%. In this scenario, the fund successfully outperformed its EAFE Index benchmark, indicating that Global Horizon's portfolio management decisions contributed positively to client returns, offering a favorable risk-adjusted return. This comparison helps Global Horizon demonstrate the effectiveness of their investment strategy.

Practical Applications

The EAFE Index has several practical applications across the financial industry:

Benchmark for International Funds: It is widely used by portfolio managers in North America as the primary benchmark for international mutual funds and exchange-traded funds (ETFs) that focus on developed markets outside the U.S. and Canada¹⁸. This allows for direct performance comparison and evaluation.
Portfolio Diversification: Investors seeking to achieve broad portfolio diversification beyond their domestic market often include assets that track the EAFE Index. This provides exposure to a wide range of developed foreign economies and industries¹⁷.
Economic Indicator: The EAFE Index's performance can serve as an indicator of the economic health and investment sentiment within the collective developed markets of Europe, Australasia, and the Far East.
Product Development: Financial institutions create investment products, such as index funds and exchange-traded funds (ETFs), that aim to replicate the performance of the EAFE Index. An example is the iShares MSCI EAFE ETF (EFA), which aims to track this index¹⁶.
Academic Research and Analysis: The historical data of the EAFE Index is frequently used in academic studies and financial research to analyze long-term trends, market correlations, and the effectiveness of various investment strategies across international markets. Access to comprehensive historical data, such as that available on Investing.com, facilitates such analysis¹⁵.

Limitations and Criticisms

Despite its widespread use, the EAFE Index has certain limitations and has drawn criticism. One key point of contention is its exclusion of the U.S. and Canada, which, while intentional for its specific purpose, means it does not offer comprehensive global exposure. Furthermore, the index's focus solely on developed markets means it omits potentially higher growth opportunities found in emerging markets like China, India, and Brazil¹⁴.

Another criticism revolves around its market capitalization-weighted methodology. While common, this approach can lead to significant concentration in a few large companies or countries within the index, potentially limiting true portfolio diversification and increasing sensitivity to the performance of those concentrated holdings¹², ¹³. For example, the index has historically been heavily weighted towards Japan and the United Kingdom¹¹.

Some analyses suggest that the EAFE Index's performance relative to actively managed foreign large-blend funds has been "tepid," partly due to its regional allocations and focus on large-cap stocks, potentially missing out on the growth from mid- and small-cap segments or specific high-growth sectors¹⁰. According to Morningstar, its performance has fluctuated around the category midpoint, which suggests that a low-cost fund tracking the EAFE Index might not always outperform a majority of active managers in the same category⁹.

EAFE Index vs. MSCI World Index

The EAFE Index and the MSCI World Index are both prominent global equity benchmarks provided by MSCI, but they differ significantly in their geographic scope. The EAFE Index specifically targets developed markets in Europe, Australasia, and the Far East, explicitly excluding the United States and Canada. Its purpose is to provide a pure-play benchmark for international equities without North American exposure.

In contrast, the MSCI World Index is designed to capture large and mid-cap stock performance across all global developed markets, including the United States and Canada⁷, ⁸. Therefore, the MSCI World Index offers a broader representation of global developed equity performance, with a substantial portion of its weighting typically allocated to U.S. equities⁶. The choice between using the EAFE Index or the MSCI World Index often depends on an investor's desired geographic exposure and whether they already have sufficient allocation to North American markets.

FAQs

What does EAFE stand for?

EAFE is an acronym that stands for Europe, Australasia, and the Far East. These are the geographic regions whose developed markets are covered by the index⁵.

Which countries are included in the EAFE Index?

The EAFE Index includes stocks from 21 developed countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom⁴. It notably excludes the United States and Canada³.

Is the EAFE Index suitable for all investors?

The EAFE Index is generally suitable for investors seeking diversified exposure to developed markets outside North America. It is often used as part of a broader portfolio diversification strategy. However, it does not include emerging markets, which some investors may wish to include for higher growth potential.

How can I invest in the EAFE Index?

Investors typically gain exposure to the EAFE Index through passively managed investment vehicles such as exchange-traded funds (ETFs) or mutual funds that are designed to track its performance. These funds aim to replicate the index's composition and returns.

How often is the EAFE Index reviewed or rebalanced?

MSCI reviews the EAFE Index quarterly (in February, May, August, and November) with the objective of reflecting changes in the underlying equity markets in a timely manner while limiting excessive index turnover². It also undergoes an annual reconstitution to ensure it remains representative¹.