What it means
An index is a basket of shares combined into a single number that rises and falls with the market. The EAFE Index is published by the index provider MSCI and covers companies in countries such as the United Kingdom, France, Germany, Switzerland, Japan and Australia.
It does not include the United States, Canada or emerging markets. The index is weighted by market capitalisation, which means larger companies have a bigger influence on its movement than smaller ones.
It is also adjusted for free float, meaning only the shares available for public trading are counted, not those locked up by founders or governments. As a result, a few very large firms in a handful of countries can have a strong effect on the index.
Fund managers use the index in two main ways. Passive funds aim to copy it as closely as possible and charge low fees, while active managers try to beat it and are judged by how far they succeed.
Pension funds and advisers also use it to set targets, for example by deciding that 20% of a portfolio should earn the return of this index. Readers should note the difference between a price return and a total return.
The price version only reflects changes in share prices, while the total return version assumes dividends are reinvested and therefore gives a fuller picture of what an investor earns. Because the shares are priced in several currencies, the index can be published in different currencies, and results for a dollar-based investor include the effect of exchange rates.
The index cannot be bought directly. Investors access it through index funds or exchange-traded funds that hold the shares in similar proportions.
The list of companies and countries is reviewed regularly, so the index changes over time, and past performance does not predict future results. When reading a performance report, check the date range and the currency used.
A fund that looks as if it beat the index over three years may have trailed it over five, and a result in local currencies can differ greatly from the same result in dollars. Asking for the exact benchmark and period avoids misleading comparisons.
In practice
Real-world examples.
Example
A pension trustee compares a fund manager's international share returns with the index. The manager earned 9% while the index earned 10%, so the trustee questions whether the fee is justified. Over a decade, even a small gap in return compounds into a large difference in the value of the fund.
Example
An adviser builds a model portfolio for clients with 25% placed in an exchange-traded fund that tracks the index. She picks it because it is low cost and spreads money across hundreds of companies in different countries. She reviews the allocation each year and tops it up if it has drifted away from the target.
Example
A financial journalist reports that international shares lagged United States shares for the year. She uses the index return as the measure of how developed markets outside North America performed. She also notes that currency moves explained part of the gap.
Formula
Calculation
Index return = ((Ending level - Starting level) / Starting level) x 100
Dollar gain on an investment = Amount invested x Index return (before fees and taxes)
Worked example: the index starts the year at 2,000 and ends at 2,200.
Index return = ((2,200 - 2,000) / 2,000) x 100 = (200 / 2,000) x 100 = 10%
An investor with $50,000 in a fund that tracks the index exactly would see a gain of $50,000 x 10% = $5,000, before fees and taxes.
If the fund charges a 0.5% annual fee, the cost is $50,000 x 0.5% = $250, so the net gain is roughly $4,750.Case study
Seen in the real world.
Lakeshore Teachers Pension Plan is a fictional fund with $200,000,000 in assets. Its investment committee was concerned that its international manager, Fennel Capital, charged a fee of 0.9% a year and had produced returns slightly below the EAFE Index in three of the last five years.
The committee compared Fennel's results with the index and with a low-cost tracker fund charging 0.1%. On $40,000,000 of international assets, the fee difference of 0.8% was worth $320,000 a year. Fennel argued that it protected investors in falling markets, but the data showed little difference in downturns.
This illustrative case led the committee to move half of the international allocation, or $20,000,000, into a tracker fund and keep the rest with Fennel under a lower fee. The case shows that a benchmark makes performance visible and fees measurable, and it gave the committee a fair basis for its negotiation with the manager.
Watch out
Common mistakes.
- Comparing a fund to the wrong benchmark, such as measuring a United States share fund against the EAFE Index.
- Using the price return when judging an income-focused fund, which understates the earnings from dividends.
- Believing the index is fixed, when its companies and weights are reviewed regularly.
Questions
People also ask.
Who publishes the EAFE Index?
The best-known version is the MSCI EAFE Index, produced by the index provider MSCI.
Can I invest directly in the index?
Not directly, but you can buy index funds or exchange-traded funds that aim to follow it.
Is the index in dollars?
It is published in several currencies, and a dollar investor needs to consider the effect of exchange rates on returns.
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