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International Active Managers Crush the EAFE, or The Japan Effect
By Rahul Seksaria
1999

In principle, international indexing should beat active international funds even more than domestic indices beat active domestic funds. That is because international expense ratios and transaction costs are even higher as a percentage of assets.

But that hasn't stopped active managers like Lilia C. Clemente, Fund Manager of Citizens Global Equity from beating Morgan Stanley's Europe, Australasia and Far East (EAFE) Index, the dominant global index over the past 10 years. "EAFE has had a tough time because the Japanese market has been tough for the past ten years," she says. By most estimates, as many as 90% of active managers have beaten EAFE in the last decade, in large part by underweighting Japan. Investors have therefore been slow to embrace international indexing.

Does this mean that international indexing can be handily beat with country picking, or was Japan's overvaluation in 1989 so obvious that indexing cannot be held to blame? The efficient market theory suggests that all publicly available information about stocks should be priced into the market. If Japan was viewed by most professional money managers as a bad long term play back then, shouldn't such investor sentiment have been priced into the Japanese stock market, which is considered to be an efficient and liquid market?

Lilia C. Clemente sheds some light on the issue: "The Japanese market has come down mainly due to structural reforms and policy decisions. It was obvious to me back then that Japan was going down because I had been following Japan for 30 years. We generally underweighted Japan over the past decade but now have overweighted Japan."

With Japan removed from the equation, fund managers had a harder time. The graph below shows how their performance has lagged Morgan Stanley's EASEA Index (EAFE Ex Japan):

Active fund managers beat EAFE but trail EAFE Ex Japan, except last year

In Europe, indexing would have worked well. Over the past ten years, fund managers have consistently underperformed (taking into account fees and expenses) the MSCI Europe Index by a few percentage points (graph below)

European fund managers have consistently trailed MSCI Europe Index over the last decade

The Japan experience emphasizes the importance of common sense asset allocation, and there is plenty of evidence that indexing in the international arena is fundamentally compelling. John C. Bogle, Senior Chairman of the Vanguard Group, writes in Bogle on Mutual Funds:

".indexing abroad should entail even more financial advantages than indexing in the U.S. The actively managed U.S.-based international funds typically have high rates of portfolio turnover and high transaction costs. In combination, these two factors may reduce returns by as much 2% annually. These actively managed international funds also normally have higher expense ratios-they averaged about 1.8% in 1992- than their counterparts investing in U.S. stocks. Total annual costs, then, may reach 3.8%. If international index funds, with much lower portfolio turnover, have transaction costs, of say 0.5% and expense ratios of 0.3%, their total costs will be 0.8%. Their theoretical annual advantage of 3.0%, then, will exceed the advantage of 2.2% that index funds in the U.S. market should theoretically enjoy."