The Synthetic EAFE Index
By Nick Ronalds and Colin Anderson

Investor appreciation of the benefits of real diversification in a well-structured portfolio appears to have made a comeback in recent years. In the late 1990s, it was not uncommon to hear the argument that sufficient diversification could be achieved by investing in U.S. giants with global businesses, such as Coke and GE. A more compelling argument, also advanced frequently noted that correlations among global bourses had been rising,  thereby diminishing the gains available from diversification.

In the past few years, however, managers have been increasing their direct exposures to foreign markets, and consultants and experts have been bumping up their recommendations for foreign exposure. Last year's flows of U.S. money into foreign corporate stock hit an all-time high. The concluding slide of a presenter at a conference sponsored by the CFA Society of Chicago in April 2006 perhaps sums up the new attitude: "International is essential, not optional."

Why is diversification back in style? There are a number of reasons. One, no doubt, is the sizzling performance of non-U.S. markets in recent years: The MSCI EAFE index returned 9.19 percent per year over the past five years vs. 2.70 percent for the S&P 500. More broadly, however, recent years have also reinforced another lesson about correlation and diversification: even highly correlated markets can exhibit significant divergence in returns over time.

Simply EAFE?

By no coincidence, the Chicago Mercantile Exchange (CME) responded to rising interest in the marketplace by launching an e-mini MSCI EAFE futures contract on March 19 of this year. The EAFE index covers Europe, Australia and the Far East, and is the most widely used benchmark for the developed world excluding the U.S. Some $1.5 trillion is benchmarked to the EAFE in the U.S. alone.

Significantly, the CME contract is dollar-denominated, which is key to its appeal. (MSCI also calculates an EAFE index based on local currency values, but the new future focuses on the dollar benchmark.) The index is calculated by converting all the constituent issues to dollar equivalents at current market exchange rates. The final settlement price is calculated the same way.

Complexly EAFE

The significance of dollar-denominating the contract can be appreciated by considering what it takes to get EAFE exposure synthetically with existing instruments. One would have to buy futures contracts for each of the EAFE countries using the appropriate EAFE weights. Then one would have to get exposure to the 11 EAFE country currencies (it is only 11 currencies because 11 of the 21 countries use the euro). Currency exposure can be obtained in one of two ways: (1) convert dollars into the currency of each country at the prevailing country rate and invest at the closest local equivalent to LIBOR; or (2) invest the cash in dollar cash equivalents at LIBOR and get the FX exposure via forward contracts in each of the currencies, again using the prevailing MSCI country weights. The two alternatives are theoretically equivalent due to interest rate parity. (While it is true that some fraction of the cash must be posted as margin, most exchanges accept government and other securities as collateral, and those returns can approximate LIBOR. Empirical evidence bears out that the interest rate embedded in the S&P 500, for example, is indeed very close to LIBOR.)

Theoretically, the hedge ratio for each futures exposure and each currency exposure changes continuously, because country weights do. A country's weight in the MSCI EAFE index is a function of the capitalization of each stock within each country's component index and fluctuations in the currencies. Neither one sits still for much longer than a nanosecond. In addition MSCI does a "major" rebalancing of the index each quarter, based on its stock selection and weighting criteria. In practice, one would choose a rebalancing schedule that balances transactions costs and tracking error.

EAFE Cocktail

We set out to analyze the performance of a synthetic index using available futures instruments prior to the introduction of the CME EAFE contract. There are many ways to replicate an index. One could populate a portfolio with 100 percent of the constituent stocks, weighted appropriately. One could use a sampling procedure for cash stocks. One could use swaps. One could use futures. One could use a combination of all of the above. The purpose of this article isn't to evaluate all these alternatives, however. Our analysis was prompted by the new CME EAFE listing, and to compare apples to apples, we used a basket of futures only-an "EAFE futures cocktail."

As would-be synthetic indexers, we quickly ran into several challenges. First, not all of the 21 constituent MSCI EAFE countries even trade a stock index contract. Second, some of the countries trade a stock index contract in such low volumes that they are too illiquid for institutional investors, which for purposes of our analysis we assumed was an investor equitizing $100 million of cash. Third, in all cases where a liquid stock index does trade, the index on which the futures contract is based differs from the country index within EAFE. Fourth and finally, one of the futures contracts, the Swiss, is closed to U.S.-based investors.

Liquidity

Figure 1 ranks the countries within the EAFE index in order of their weight within the index; it also lists the volume of futures contracts traded in 2005. An "NA" in the volume field means that no tradable futures contract exists in that country. What's striking about the data is how suddenly the liquid contracts stop. The first 11 countries by EAFE weight, from Japan through Hong Kong, all traded millions of index futures contracts in 2005. The next country by weight after Hong Kong, however, was Finland, and its contract no longer trades. Belgium, Singapore and Norway trade only modestly, especially considering the low contract values of the latter two. Austria and Portugal trade just a few hundred contracts a day, while the smallest country by EAFE weight, New Zealand, no longer has a viable contract.

Given these numbers, we felt it made sense to draw the line after Hong Kong; that is, to attempt to replicate the MSCI EAFE using just the most liquid 11 of the 21 EAFE countries, from Japan to Hong Kong. The situation is not as bad as it seems: these top 11 countries ("basket countries") make up about 93 percent of the whole EAFE index by capitalization.

Allocating The "Outs"

The next question is, how do we allocate the countries excluded from the synthetic index? We opted for the simplest approach first; we allocated the weights for the ten "out" countries (Finland through New Zealand) among the 11 basket countries in proportion to their weights. For example, if Japan has a weight of 30 percent among the liquid 11 countries and France has a weight of 12 percent in a particular month (as noted, weights change regularly), each of the dropout countries would be allocated 30 percent to Japan and 12 percent to France, and so on.

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