Continental shift

The relative robustness of the continental European economies has helped stocks across the region rebound strongly from their March lows, as Nick Sudbury reports

Global stock markets plunged sharply at the start of last year, but since then a combination of low interest rates and concerted action by world leaders to stimulate their economies has helped bring about a dramatic recovery. All the evidence suggests that Europe has come out of the credit crisis in a stronger position than many of the other developed regions. 

European government finances are not as overstretched as they are in the UK and the US so the twin threat of higher taxes and lower public spending is not as acute. The European Central Bank has also won many plaudits for its robust anti-inflationary stance. This has enabled the euro to strengthen against weaker currencies like the pound, thereby providing an important additional boost for UK based investors. 

Strong recovery 

The improvement in sentiment has allowed stocks in Europe to rally sharply from their March lows. This has enabled the ETFs investing in the region to make positive returns over the year. One of the best performers in this time period was the PowerShares FTSE RAFI Europe fund, which was up 35.47%. 

Tim Mitchell, head of listed fund sales at Invesco Perpetual explains the RAFI Europe ETF is designed to track the performance of the largest companies in the region based on fundamental factors as opposed to their market value. 

“We use a stock weighting methodology that is not linked to the share price. This means that we do not automatically overweight overpriced companies like a cap-weighted index and over time this has been shown to add 2% or 3% to the annual performance,” he says. 

The RAFI methodology looks at the book value, cash flow, sales and dividends of a company to provide a measure of its true value. This is then used to determine its weight relative to the other index constituents. When the market is behaving in a rational manner the RAFI fund will perform similarly to the cap weighted indices, but if there is a lot of fear or greed then the differences between the two methods will be bigger. 

“Early last year when the market panic was at its height the share prices of many banks were pushed below their fundamental value. This meant that the RAFI fund had a ten times bigger weighting in Barclays than the FTSE 100, which generated a lot of outperformance,” explains Mitchell. 

Performance boost

Most of the gains have come in the last six months and have been primarily driven by the strong rebound in the underlying equity markets. Two of the best performers during this period were from Amundi, the group comprising the asset management of Crédit Agricole and Société Générale, with the CASAM MSCI Europe High Dividend and MSCI Europe Value ETFs rising 24.1% and 22.4% respectively. Both provide exposure to value stocks, which are companies that appear to be underpriced by the market compared to their asset value or earnings growth. 

Valérie Baudson, managing director of CASAM ETF, explains that CASAM MSCI Europe High Dividend aims to closely replicate the net return performance of its benchmark in euros. “The index is comprised of around 110 stocks with the highest dividend yields from across the 16 European markets.” 

CASAM ETF MSCI Europe Value is a more diversified fund. This holds close to 300 leading value stocks from the 16 countries in the region. As with the other CASAM fund it is benchmarked in euros. Both have had a similar sector breakdown with high exposure to areas such as financials, energy, utilities and telecom services.

Baudson says that each of these funds uses a swap-based replication model. “An index swap ensures that the ETFs receive the precise index return before management fees and hence lower tracking error compared to physical replication. The swaps are agreed on with the Crédit Agricole group, which is AA rated.” 

The counterparty risk generated by the swap is limited to 10% of the net asset value of each fund in accordance with the Ucits III rules. All the remaining 90% of the assets are invested in European shares. 

In the last six months these two value styled funds have outperformed CASAM’s equivalently styled growth ETF. This is largely because products like CASAM ETF MSCI Europe Growth have a bigger weighting in defensive stocks than in the cyclicals. 

“Last year the equity markets were driven by the recovery of cyclical and financial stocks, which were the areas that suffered the most in 2008. The two value-oriented CASAM ETFs are highly exposed to the performance of these sectors,” explains Baudson.

She adds the valuation of cyclical stocks is now quite high and widely anticipates an end to the crisis. “This suggests that investors might regain their interest in growth stocks, which could start to outperform value later in the year.”

The bigger picture 

Despite the credit crisis the returns from the region over the last five years have been impressive, with 15 of the funds available throughout the period producing an average gain of 40%. The top performers include two ETFs from iShares that are benchmarked against MSCI EMU and the S&P Europe 350 respectively. Each has risen more than 40% over the five years. 

Nizam Hamid, head of iShares sales strategy Europe, explains that the MSCI EMU fund only covers the euro land block of countries, whereas the S&P 350 spans the whole of Europe. 

“If an investor wants to have exposure to a broad European benchmark then MSCI Europe would be the ideal option. The index is fully diversified across the region’s countries and sectors so there would be no need for people to spread their capital across any other European funds. Alternatively they could use an ETF benchmarked against the Stoxx 600,” he says. 

Both these iShares ETFs are US based funds that invest in the actual underlying shares. It is also important to bear in mind the significant contribution that the exchange rate movements have had on their returns. 

“Over the last five years MSCI EMU, in euro terms, has returned 15.7%, whereas from a sterling perspective UK based investors have enjoyed a gain of 45.3%, so clearly the currency has been a dominant component of the total return,” comments Hamid. 

Views differ as to whether the euro will continue to strengthen against the pound. A lot depends on the result of the UK general election and the willingness of the government to tackle the high public debt. Early concerted action would be likely to strengthen sterling and undermine the returns from European funds, whereas any significant delays would have the opposite effect. 

Click here for a table of Eurozone ETFs