European stocks can diversify a portfolio and lower the amount of risk, especially since the U.S. stock market has been extremely volatile.
While European stocks still have a relatively high correlation to U.S. stocks in the long term, there are pockets of opportunity for European stocks to diversify U.S. stocks during shorter time frames, says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional. The 10-year correlation using monthly returns of MSCI Europe and the S&P 500 is 0.84.
The rolling 36-month correlation has been as low as 0.44 in the period ending September 2018.
One drawback of investing in European stocks is that the MSCI Europe has underperformed the S&P 500 significantly annualized over the past one, three, five and 10 years. Over those respective periods, the S&P 500 gained 5.4%, 8.6%, 8.5% and 11.6%, while the MSCI Europe returned -8.5%, -2.7%, -1.3% and 2.7%. Many investors are fearful that trend can continue, she says.
European stocks are also susceptible to currency risk, and moves in foreign exchange rates could cause a possible loss or a gain, says Mike Loewengart, managing director of investment strategy of E-Trade.
The U.S. dollar has been declining as investors are wary of the still-growing health crisis and how it will impact the economy.
European stocks are more negatively correlated with a falling U.S. dollar. If other factors are all equal, a falling U.S. dollar is better for European stocks, Gunzberg says.
There is a likely chance the U.S. dollar will depreciate in the coming months, she adds. Based on monthly data to the S&P 500, the 10-year correlation of the U.S. dollar is -0.41 and is -0.64 to the MSCI Europe Index, which holds in the very long term.
“In the past 10 years, on average for every 1% year-over-year decrease in the U.S. dollar, the S&P 500 rose 3% on average, while the MSCI Europe rose 2.3% on average,” Gunzberg says.
Role of Sectors in U.S. vs. European Markets
The U.S. places greater emphasis on the tech sector, while Europe is focused more on health care. The largest sectors in the S&P 500 are 27.5% in information technology, 14.6% in health care, 10.8% in consumer discretionary and 10.8% in communication services. The MSCI Europe is 16.5% in health care, 15.1% in financials, 14.8% in consumer staples and 13.4% in industrials, as of June 30.
The energy and materials sectors are much heavier in the MSCI Europe at 4.7% and 7.6%, respectively, compared with the S&P 500 at 2.8% and 2.5%.
The concentrations in the various sectors are important because the inflation hedge is more powerful from European stocks, even to the U.S. Consumer Price Index, Gunzberg says. In the past 10 years, on average for every 1% year-over-year increase in the U.S. CPI, the S&P 500 rose 2.4% on average, while the MSCI Europe rose 4.3% on average.
“The sectors you’re exposed to in Europe tend to be more heavily weighted to old-line economy areas like health care, industrials and consumer defensive stocks,” says Chris Sipes, managing principal of Sonoma Wealth Advisors in California. “The Asian and BRIC markets are increasingly led by technology, communication services and financials.”
Investors seeking more income from their investments turn to stocks with higher dividend yields. The dividend yield from MSCI Europe is higher at 2.73% than for the S&P 500 at 1.86%, and the European stock valuations are cheaper with MSCI Europe price to earnings of 15.86, while the S&P 500 price to earnings is 22.22, Gunzberg says.
The U.S. utilities sector provides generous yields, but European utilities offer a broader diversity of business mix than U.S. ones by including more solar and wind generation, says Jean-Hugues de Lamaze, managing director and senior portfolio manager at London-based Ecofin Advisors Limited.
“Europe combines different cultures but also market structures and regulatory frameworks,” he says.
“Regulatory frameworks are specific to each country. This gives investors plenty of investment opportunities with diverse investment characteristics and risk profiles across Europe.”
How to Invest in Europe
There are five direct benchmarks that measure more than half of the European Union’s gross domestic product, including the German DAX 30, French CAC 40, British FTSE 100, Italian FTSE MIB 40 and the Spanish IBEX 35. Since France and Germany carry much of the European influence, the CAC and DAX represent much of the European economy, says Stuart Michelson, a finance professor at Stetson University in DeLand, Florida.
Many investors rely on European indexes provided by FTSE or MSCI as their benchmark for performance and returns.
“The European market is a home to many leading worldwide firms such as consumer goods, energy and health care,” he says. “Investing in European stocks provides many blue-chip stocks to select to add diversification and value to an investor’s portfolio.”
Maintaining a home country bias by investing mostly in U.S. large-cap stocks can leave blind spots in your total investment portfolio, Loewengart says.
“In our pandemic era and on the heels of the EU’s historic $2.1 trillion stimulus bill, Western Europe has proven that they can work together and has been pretty effective in combating the spread of the virus,” he says. “These developed countries abroad have demonstrated a strong thesis for potential long-term growth opportunities.”
Many domestic companies have global exposure and rely heavily on international economies. The simplest way for investors to gain exposure to the European market is through mutual funds such as T. Rowe Price European Stock Fund (ticker: PRESX) with an expense ratio of 0.97% since it is actively managed and iShares MSCI EAFE Growth ETF ( EFG) with an expense ratio of 0.4%.
“Before investing, take inventory of your current holdings to avoid becoming concentrated in any one area of the market,” Loewengart says. “European stocks are also susceptible to currency risk — meaning moves in foreign exchange rates could cause a possible loss or a gain. Funds can do most of the heavy lifting when it comes to investment selection, but be sure to do your homework before investing to align with your risk tolerance, time horizon and goals.”
European equities are an important part of a diversified global asset allocation in equities alongside U.S. and Asian equities and emerging and frontier markets, Gunzberg says. It is common to see 5% to 15% of an investor’s portfolio allocated to European equities.
Investors who opt to invest in a global market cap strategy through ETFs could allocate 13% to 17% European companies, Sipes says.
The iShares Europe ETF ( IEV) is weighted by the market capitalization of the stocks and carries a 0.59% expense ratio. This fund is available on most platforms and gives investors broad-based exposure. There is a currency hedged version, iShares Currency Hedged MSCI Eurozone ETF ( HEZU), that has performed better over recent years due to the strength of the U.S. dollar, he says. The expense ratio is 0.52%.
The Vanguard FTSE Europe Index ETF ( VGK) is market cap weighted and follows a benchmark, the FTSE Developed Europe All Cap Index, and holds 1,321 stocks. The expense ratio is a slim 0.08% and is a good option if “you’re looking for the rock-bottom price without giving up performance,” he says.
The WisdomTree Europe Hedged Equity Fund ( HEDJ) is a currency-hedged ETF and one choice for people looking for a currency-hedged option with a fundamentally based weighting scheme. The expense ratio is 0.58%.
European stocks can be risky, and that includes factoring in the exchange rate and economic, political, regulatory and business conditions related to investing in a foreign country, Michelson says.
“An investor may make a profit on a European stock, but the value of the euro may strengthen with respect to the U.S. dollar, which may cause the investor to lose money on a profitable stock investment after currency conversions,” he says.
European stocks can be purchased through many traditional U.S. brokerage accounts, and investors could consider adding Vodafone Group ( VOD), Nestle (NSRGY) and Roche Holding (RHHBY), Michelson says.
Vodafone Group is a multinational telecommunications company that provides a range of services, including mobile services, financial services and fixed networks in Asia, Europe, Africa and the Middle East. Vodafone offers mobile operations in 25 countries and has partner networks in 47 additional countries.
Nestle is a Swiss multinational nutrition, wellness and health company. Nestle is known for being the largest food company globally.
Roche Holding is a Swiss multinational health care company that operates worldwide in pharmaceuticals and diagnostics. Roche is the second-largest pharmaceutical company globally.
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