Beating the EAFE index in the coming decade will require multiple correct decisions, according to leading money managers, not the one that sufficed in the '90s.
Getting Japan right -- which meant underweighting it -- was the key to bettering the Europe Australasia Far East index calculated by Morgan Stanley Capital International in the past 10 years.
In fact, the average manager outperformed the EAFE by 270 basis points in the decade ended Sept. 30, according to Frank Russell Co., Tacoma, Wash. (For 10 years ended Sept. 30, the EAFE was up 6.1% compounded annually.)
"It's been great to be underweight Japan for the past 10 years," said Gary Motyl, president and portfolio manager with Templeton Investment Counsel Inc. in Fort Lauderdale, Fla.
Now, however, active international equity managers paint a picture of a world that requires them to make a variety of decisions -- from selecting sectors and regions to beefing up their research -- to outperform the index.
The technology sector will be a key decision, many said. "If you don't get technology right, it might be hard to beat EAFE," said John Boich, senior portfolio manager with Montgomery Asset Management LLC in San Francisco.
"The tech sector call is going to become increasingly more important," said William Andersen, a senior vice president and international portfolio manager with Driehaus Capital Management Inc. in Chicago. And technology stocks are pushing firms like Driehaus to have a truly global presence. "What happens on the Nasdaq affects the over-the-counter market in Japan and tech stocks in Europe," Mr. Anderson said.
Driehaus runs about $2.2 billion in its EAFE portfolio for U.S. tax-exempt investors.
And managers will need to understand how a broad array of companies -- from carmakers to drug manufacturers --apply technology if they want to pick the best stocks, said William Sterling, president and chief investment officer of Trilogy Advisors in New York.
"We think that the next big explosion in growth is the biotech sector," said Stephen Waite, Trilogy managing director and portfolio manager. He points to the fact that only one biotech firm, Amgen Inc., is in the MSCI World index, which includes close to 1,400 companies. Aging populations across the developed world will fuel the demand for medicines developed with new technology, he said.
No doubt, the world of international money management is much more crowded than it was 10 years ago. About 60 active international managers have been around long enough to record 10-year track records, according to Pensions & Investments' Performance and Evaluation Report. And that number more than doubled in the '90s.
With a host of new funds chasing stocks overseas, managers will have to emphasize bottom-up stock picking in hot sectors over country allocations to beat the benchmark, many agreed.
But Japan is still an essential factor. Making the wrong decision about Japan during the next 10 years could prove costly, some managers said. "It's too dangerous to be out of the Japanese market, but you have to be careful when you're in it," said Nicholas Reitenbach, chief investment officer with Pinnacle International Management LLC, New York.
Pinnacle has close to $530 million in its EAFE portfolio.
Managers overall have changed their strategy regarding Japan. Markets there have staged a minicomeback this year, with the Nikkei 225 up 30.6% through Dec. 21.
Many active international managers have upped their positions in Japan in the past year. Some are at or close to a full weight for the first time in years. That means competition for the right stocks has intensified.
"Now that firms have established a 20% weighting in Japan, it comes down to stock picking -- not sector rotation," said Mr. Reitenbach.
"If managers don't get Japan right, they'll have a hard time making it up," said Deborah Chaplin, senior portfolio manager, international equities, for Scudder Kemper, which manages $15 billion in its core EAFE portfolio for U.S. pension funds and other tax-exempt investors.
Another challenge facing international investors who run money for leading U.S. pension funds comes from their clients. A number of leading U.S. funds have changed their benchmarks to the MSCI All Country World index ex-U.S. This spells trouble for managers accustomed to competing with the EAFE benchmark, some believe.
"I disagree with the view that sectors will replace countries or regions," said Steven Schoenfeld, head of international equity strategies with indexer Barclays Global Investors, San Francisco. But, he conceded, "sector research will matter within new economic blocks" like the European Monetary Union.
And he noted the ACWI ex-U.S. index includes emerging markets and Canada, which are left out of EAFE.
"The ACWI benchmark is broader," said Mr. Schoenfeld. "There's no one country dominating it. Managers need to get a series of countries right or wrong."
The ACWI ex-U.S. universe is bigger than the EAFE's. It includes 49 countries and about 2,000 companies vs. EAFE's 20 countries and close to 1,100 companies.
The mundane issue of research might be the key that separates the managers that outperform international indexes.
There's a difference between money managers that do "primary, original research and secondary research that comes from the brokers" about overseas companies, said Montgomery's Mr. Boich.
The crowded field of international money managers often chases stocks touted by brokers, he said. He guessed about 75% of firms rely on secondary research, with the rest, including Montgomery, doing both.