Some active international equity managers might have lower excess returns due to revision of the Morgan Stanley Capital International Europe Australasia Far East index, but the vast majority still should be able to provide respectable alpha over the index.
That was the opinion of money managers, consultants and pension fund sponsors questioned about a new report from Barclays Global Investors, San Francisco, which said active managers will have a hard time beating the revised EAFE index. Index revisions will be finalized at the end of May.
"It may be harder, but not impossible, for active international equity managers to beat EAFE," said Thomas R. Hancock, a partner in Grantham, Mayo, Van Otterloo & Co. LLC, Boston, which has $4.3 billion in active accounts benchmarked to EAFE.
Top-quartile active international equity managers who have had an excess return of 500 basis points over EAFE may well see it fall to about 250 basis points over the revised EAFE, according to Paul Ehrlichman, a managing director of Brandywine Asset Management, Wilmington, Del.
"The odds favor the indexes' being harder to beat and for excess return expectations to moderate," said Mr. Ehrlichman. He pointed out, however, that the top quartile active U.S. domestic equity managers usually beat the Standard & Poor's 500 index by about 250 basis points, so the return now should be about the same.
Size and style
"To a greater degree (active international equity) managers are going to be asked to define themselves in terms of size and style, with pension fund sponsors asking `how do you get your alpha?"' said Mr. Ehrlichman. Brandywine manages $750 million in active accounts benchmarked to EAFE.
He also said style could become a more important element in an active international equity manager's return, with growth and value dominating the portfolios and providing alpha at different times.
"We've done a lot of analysis and what we see is a slight change, a moderate change to geographic makeup and to stock weightings," said Erik Granade, chief investment officer for INVESCO Global Asset Management, Atlanta. "I don't believe the revisions in the benchmark will have an influence on the ability to beat the benchmark."
He pointed out that one of the changes BGI mentions in its report is the lower weighting of Japan in the new index, stating there were active managers who were able to beat the old index by underweighting Japan. Mr. Granade said Japan's weighting in EAFE actually has been falling for more than 10 years. It peaked around 65% at the top of its stock market bubble in the late 1980s and is about 19% in the revised EAFE. "It's not a salient point for the shift from market capitalization to free float to say underweighting Japan has helped anyone beat the index recently or won't help it in the future," he said.
"It's a zero-sum game," Mr. Granade said about the changes in EAFE and active managers' ability to beat the index.
Adding value
"(International investing is) still an area where active managers can add value," said William Quinn, president of AMR Investment Services, Fort Worth, Texas, which oversees the $11 billion American Airlines pension fund. "We may not have the extreme results we've had over the last few years, but if active managers can add 100 to 200 basis points return over the index, we're going to be happy."
Matthew Scanlon, a principal in BGI and one of the authors of the report, said the paper doesn't say it will be impossible for active managers to add value over EAFE, but that the opportunities will change.
"International portfolios have a higher cost structure than U.S. portfolios do, and they (international portfolios) will have to be broader, with managers taking smaller bets than in the past," he said. "The easy layups won't happen."
Mr. Scanlon predicted this could lead to a "core-satellite" approach to international investing, similar to what many plan sponsors use for their U.S. domestic equity exposure. Plan sponsors will have an indexed core international mandate, with active international managers taking small, active bets around the index.
"The opportunities to take active risk by country allocation and sector allocation haven't changed much," said Steven Bleiberg, managing director of Credit Suisse Asset Management, New York. He noted that while some observers have pointed to major changes in the telecommunications stocks in the EAFE index, with weightings of companies changing and the inclusion of new companies, "they didn't change that much. You can still take active moves around sector weights," he said.
Mr. Bleiberg also said, "I never really bought the argument that (foreign) markets were less efficient," as the BGI report states. He thinks the claim was simply "arrogance by U.S. investors."
"It's not like they were sleepy backwater markets," he said. "I don't think it will be any harder than before to beat them because of greater efficiencies."
More efficient?
"I don't know that the revisions make the indexes that much more efficient," said John R. Krimmel, chief investment officer of the State Universities Retirement System of Illinois, Champaign. He pointed out there are more than 1,000 stocks in the revised EAFE index, "which gives active managers more opportunity to add value."
Moreover, he said that if the U.S. dollar weakens later this year, as has been predicted by many economists, "currency could become a big play (in international equity returns) going forward."
Scott Seery, director of international investments for the Florida State Board of Administration, Tallahassee, said, "I'm not sure, given the degree of tracking error active (international) managers tend to have, if it (the changes in EAFE) will hurt them."
