BGI Announces First Style-Based International ETFs

[Bylo Selhi]

Barclays Global Investors Announces the Launch of the First Style-Based International Exchange Traded Funds for U.S. [and Canuck] Investors

Barclays Global Investors announced today that the iShares® MSCI EAFE Value Index Fund (NYSE:EFV - News) and the iShares® MSCI EAFE Growth Index Fund (NYSE:EFG - News) began trading on the New York Stock Exchange. Each fund's expense ratio is 0.40%...

The MSCI EAFE Value and Growth Indices are subsets of the MSCI EAFE Index and constituents include securities from Europe, Australasia and the Far East. The indexes each generally represent approximately 50% of the free float-adjusted market capitalization of the MSCI EAFE Index. MSCI uses a specialized framework to attribute both value and growth style factors to the MSCI EAFE Index constituents, which are then used to calculate a value score and growth score. Based upon these two scores, MSCI determines the extent to which each security is assigned to the value or growth style. It is possible for a single security to have representation in both the value and growth style indexes, however no more than 100% of a security's float-adjusted market capitalization will be included within the value and growth style indexes.

[Norbert Schlenker]

Whoa, Nellie!

Before I invested in something like this in a taxable account, I'd like to know what the annual turnover is likely to be. MSCI isn't very forthcoming about their "framework".

I've written to BGI to ask them if they have retrospective stats on turnover. I'll let y'all know what I hear back.

[DenisD]

IndexUniverse has info on past performance.

Although past performance is no guarantee of future success, international value has dominated international growth over the past three decades, outperforming in twenty of the past thirty years. The cumulative performance is even more striking: $100 investing in the EAFE Value Index thirty years ago would be worth $2,723 today, versus just $1,043 for the growth index.

[Norbert Schlenker]

Oh, it's way worse than that graph indicates. That's a price graph. Value has the added advantage that it usually pays more dividends. What you really want to compare is total returns.

Both of the indices were started at 100 at the end of 1974. At the end of July this year, the growth index in total return terms was at 1933.38. The value index was at 6774.12. (EAFE itself was 4052.84.) The 30+ year compounded annual returns are

Code: Select all

EAFE Value  14.78%
EAFE Growth 10.17%
EAFE        12.59%

It's a compelling story in a non-taxable account. In a taxable account, though, it's a different story. The advantage of EAFE Value over Eafe Vanille is ~2% a year pre-tax.

But how much of the extra return comes from higher dividends on Value versus Vanille? I don't know but I would be surprised if the average yield differential over the period wasn't as high as 3-4%. Apply taxes to that and the gap closes considerably.

Another crucial variable is turnover. EAFE Vanille has negligible turnover. I will be surprised if I get a number out of BGI that's less than 20% annually for EAFE Value; I wouldn't be surprised if it were much higher. That sort of turnover means capital gains taxes sooner rather than later, which again cuts into the total return gap.

[Norbert Schlenker]

But how much of the extra return comes from higher dividends on Value versus Vanille? I don't know but I would be surprised if the average yield differential over the period wasn't as high as 3-4%.

Time to eat some crow before someone else presents it on a plate.

Since the inception of the value and growth series in 1975, the extra dividend yield on EAFE Value versus EAFE has averaged 0.4% a year. It has never been higher than 1% in any calendar year. So much for that argument.

Another crucial variable is turnover. EAFE Vanille has negligible turnover. I will be surprised if I get a number out of BGI that's less than 20% annually for EAFE Value; I wouldn't be surprised if it were much higher. That sort of turnover means capital gains taxes sooner rather than later, which again cuts into the total return gap.

Modelling this (plus the dividend gap) with 40% taxes on dividends and 25% taxes on capital gains, the incremental tax drag on Value over Vanille is 1.1% per year at 20% turnover.

That differential is not very sensitive to changes in turnover (1.0% at 10%, 1.2% at 50%), nor to changes in the tax rate on foreign dividends. It is pretty sensitive to changes in tax rates on gains, e.g. setting the rate on gains to 36%, which was about as bad as cap gains rates got in Canada during the period in question, raises the tax drag to about 2% a year.

Mitigating that is a much larger unrealized gain in Vanille at the end of the period - hence a much larger contingent tax cost - than in Value, where the residual unrealized gain is smaller. OTOH, the model uses a very naive model of turnover, selling a fixed portion of each portfolio every year. For Value in particular, which would have a tendency to sell securities that had appreciated more and keep securities that appreciated less in any given year, the model probably underestimates the tax drag.

Take what you like from those numbers. If past performance is any guide, then Value looks like a good long term bet in a non-taxable account. In a taxable account, the advantage is smaller, probably by at least 1%, perhaps vanishing altogether.

Mmmm, crow. Tastes just like chicken.

[Bylo Selhi]

Take what you like from those numbers. If past performance is any guide, then Value looks like a good long term bet in a non-taxable account. In a taxable account, the advantage is smaller, probably by at least 1%, perhaps vanishing altogether.

One more complication to toss into the pot re how best to hold these ETFs. Tax on distributions from foreign securities owned by the ETF are often withheld by the home country's revenooers. This can range from 15% to 35% (or more?) of the distribution. When the ETF is held in a taxable account, that tax is recoverable as a foreign tax credit. However when held inside an RRSP/RRIF it's a dead loss and worse, when you redeem from the account, you get to pay tax on it a second time.

[DenisD]

I'm hoping MSCI will come out with EAFE style indices with a neutral band. Similar to those from MSCI Vanguard uses with their US ETFs. ISTM the neutral band approach is better because:

- Greater value or growth slant than the 50/50 approach.

- Less turnover.

Maybe when Vanguard releases their EAFE style ETFs.