Monday, December 25, 2006

From Style Box to Style Cube: The iShares EAFE Indices

In my recent post to the Trader Performance page of my personal site, I suggested that I viewed ETF trading through the lens of a "style cube", rather than the traditional "style box". We have already seen two dimensions of the style cube: large cap-small cap and value-growth. The important third dimension to the cube we might call "domestic-international": investing in the U.S. vs. investing internationally.

To illustrate two of the cube dimensions, I've created the chart above, which tracks the iShares EAFE Value Index ETF (EFV), the iShares EAFE Growth Index ETF (EFG), and the S&P 500 Index ETF (SPY). Prices have been adjusted for equal value at the start of 2005.

Before we examine the chart, however, allow me to comment on the MSCI EAFE Index. EAFE refers to Europe, Australia, Far East. The index consists of companies in the developed world outside the U.S., with liberal weighting of Japan, U.K., and continental Europe. The ETF covering the MSCI EAFE Index itself is EFA, and it has become an increasingly popular investment and trading vehicle. EFV and EFG break down the Index into value and growth components, so that we can see how those market segments perform relative to one another.

At this point in time, we don't really have ETFs developed for the small cap/large cap portions of the EAFE Index. What we do have, however, is the iShares MSCI Emerging Markets ETF (EEM), which represents international markets in the developing world. To the extent that we view the emerging markets as "small cap", we could think of EEM as representing the international-small cap space on the cube and EFA as representing the international-large cap space. Eventually, as Russell Wild points out in his excellent "Dummies" book on Exchange-Traded Funds, we will likely see actual small-cap and large-cap versions of the EAFE Index itself.

So now to the chart. Notice that value has been outperforming growth among the EAFE stocks, similar to what we've seen in the U.S. market. There is, however, quite a gap in performance between both EAFE subindices and the U.S. large cap market. Traders have done better by being in value than growth, but they have especially profited when they've been in international markets vs. the U.S.

The style cube is simply a way of organizing our thinking about equity performance. Which segments of the market represent the greatest opportunity? Which have the greatest flows of funds? Should we weight our portfolios toward international or U.S.? Toward large cap or small? Toward value or toward growth? With ETFs, any individual investor can become a relatively sophisticated money manager.

I would argue, however, that the style cube ETF options will also become increasingly relevant for shorter-term traders, who will provide much of the growing liquidity in ETFs. Traders will be attracted to ETFs that are trending, those that are showing relative strength, and those that have good volatility for intraday moves.

The day of limiting trading to the major indices (SPY or QQQQ) in the U.S. or even to individual U.S. stocks is rapidly coming to an end. Markets are global, and ETFs permit increasingly global participation by the individual trader. That not only includes the equities that make up the style cube, but also the trading and investment options among the growing number of commodity, currency, and fixed income ETFs. I will be covering those in future posts.