What it means
The term was created for investors who wanted a simple way to describe the world's developed markets outside their home country. For United States investors, EAFE means everything in the developed world apart from the United States and Canada.
It does not include emerging markets such as Brazil, India or most of Africa. The region is dominated by a few large economies.
European countries such as the United Kingdom, France, Germany and Switzerland make up a large share, and Japan is the biggest single market in the Far East. The mix changes over time as companies grow, shrink or move.
Investors use EAFE as a category when building portfolios. A fund manager might describe an allocation as 60% United States shares, 25% EAFE and 15% emerging markets, which is a quick way to show diversification across regions.
Funds labelled EAFE are managed to track or beat the performance of these markets. Holding EAFE assets brings both benefits and risks.
They can spread risk because economies do not move in lockstep, and they often have different sector mixes, with more banks, industrial companies and consumer brands and fewer technology giants than the United States market. They also expose the investor to currency movements, because the shares are priced in euros, pounds, yen and other currencies.
The acronym is also the basis for a well-known index, the MSCI EAFE Index, which tracks the performance of large and mid-sized companies in these markets. The term EAFE refers to the region, while the index is a specific measuring tool.
The list of countries in the region is decided by the index provider and may change over time. Costs and structure matter when choosing an EAFE investment.
Funds range from low-cost passive trackers to actively managed portfolios with higher fees, and some hedge the currency exposure back to the investor's home currency. Over a long period, differences in fees and hedging can have as much effect on the final result as the choice of region.
In practice
Real-world examples.
Example
A retired investor holds a portfolio of home-country shares and wants broader diversification. Her adviser suggests placing 20% of the portfolio, or $100,000 of $500,000, in an EAFE fund. She explains that this adds exposure to hundreds of companies in different countries with a single holding.
Example
A pension fund board reviews its asset allocation and finds that only 10% is invested outside its home market. It decides to raise its EAFE target to 20% to reduce reliance on one economy. The board agrees to phase the change in over 12 months to avoid investing everything at a single price.
Example
A multinational company's treasury team invests surplus cash in a short-term fund holding securities from EAFE countries. The team notes that returns will be affected by the value of the dollar against the euro and yen. If the dollar strengthens, the converted returns will be lower than the returns in local currencies.
Case study
Seen in the real world.
Oakmont Family Office is a fictional adviser managing $10,000,000 for several families. Its clients' portfolios were almost entirely in domestic shares. The senior partner, Ms Rahman, argued that this concentrated the risk in one economy and one currency.
She proposed an allocation of 20% to EAFE shares, worth $2,000,000, split between a European fund and a Japanese fund. Over the next three years, the domestic market rose strongly while EAFE lagged, and some clients wondered whether the move had been wise.
Ms Rahman explained that diversification is meant to reduce the overall risk, not to beat the best market each year. This illustrative case shows that international allocation is a long-term decision, and in later years EAFE markets led. The families kept the allocation, and the partners agreed to rebalance it once a year so that it stayed near 20% of each portfolio.
Watch out
Common mistakes.
- Assuming EAFE includes emerging markets, when it covers only developed economies. Investors wanting emerging market exposure need to hold a separate fund or index for it.
- Forgetting currency risk, so a good local share price can still produce a poor return after conversion into dollars.
- Treating all EAFE countries as one economy, when Japan, the United Kingdom and Switzerland behave very differently. Each has its own interest rates, currency and industry mix.
Questions
People also ask.
What does EAFE stand for?
It stands for Europe, Australasia and the Far East.
Does EAFE include the United States?
No, it excludes the United States and Canada, because it is designed to describe markets outside North America. Investors outside the United States often use different regional labels.
Is EAFE an index?
EAFE is a regional label, and the best-known index built on it is the MSCI EAFE Index.
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