Europe may be better to invest in than you think

If you’ve been an index investor in Europe these last several years, you’ll have taken your lumps. Between sovereign debt crises, political disintegration and non-existent growth, it’s been the worst-performing of the major investable regions since the last recession. But a turning point may be at hand. In its April ETF strategy report, National Bank of Canada Financial Markets went so far as to suggest investors take some of their profits on U.S. equities and add weight to their European holdings.

The rationale for this tactical shift has as much to do with the state of American markets as of those across the pond: There’s a growing political risk, evidenced by the health-care debacle, that the new administration in Washington, D.C., will not be able to deliver much on its agenda—all while U.S. equity valuations remain stretched. “The potential for disappointment in the United States is gradually increasing, as it seems the president is unable to fully rally the GOP behind his plans while we believe C,” National Bank analysts Daniel Straus and Ling Zhang wrote. Profit growth there is well distributed across different industries, whereas in North America it’s overwhelmingly coming from the energy sector.

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It’s a thesis Alan Fustey, vice-president and portfolio manager with Index Wealth Management in Winnipeg, nods along with. “European equities right now are definitely cheaper on an absolute and a relative basis versus U.S. equities,” he says. According to index tracker MSCI, U.S. stocks are trading at a rich 24 times their earnings over the last 12 months. By that measure, European stocks are trading at a 22% discount to American stocks, compared to an average discount of 17% over the past five years.

And while there’s a risk of populist candidates coming to power in French and German elections later this year, the economic backdrop is actually improving. The Eurozone recently hit its 2% inflation target for the first time since 2008. Moreover the Dutch election in March showed populism is not some unstoppable force. “I think there’s a good opportunity here in Europe compared to the U.S. over a one-year time frame,” Fustey says.

Just how to get that European exposure might be tricky, however. When choosing an ETF, “you do have to be very careful about the underlying index,” says Mark Yamada, president and CEO of PUR Investing Inc. in Toronto. Virtually all the European-specific ETFs on the Toronto Stock Exchange include the United Kingdom—indeed, British stocks represent their largest component. As the U.K. extracts itself from the European Union and some financials (and their jobs) relocate to other countries, the U.K. could prove to be a drag on any rebound on the the continent, Yamada says.

If that is a concern, you may want to opt for a Eurozone-specific ETF traded in New York. Conversely, if you’re a couch-potato investor with just a few funds, an EAFE fund (for Europe, Australasia and the Far East) will have 70% to 75% exposure to Europe. Says Yamada: “It’s important to know what the underlying holdings are.”

European stock ETF best bets

Vanguard FTSE Developed Europe All-cap Index (TSX: VE) — Broad cap-weighted fund encompassing 1,300 stocks, with a modest MER of 0.22%; excludes Emerging European countries such as Poland and Hungary. Comes in a currency-hedged version too (VEH).

iShares MSCI Europe IMI Index (XEU) — Similar to VE, but benchmarked to a different index of European stocks. Also available in hedged version (XEH).

Horizons Euro STOXX 50 Index (HXX) — Large-cap fund weighted to multinational corporations. Low MER of 0.19% but may charge swap fees of up to 0.30%.

BMO MSCI Europe High Quality Hedged (ZEQ) — With its heavy weighting to consumer staples, health care and industrials, “it’s a good diversifier for Canadian investors,” says PUR Investing’s Mark Yamada.

SPDR EuroSTOXX 50 (NYSE: FEZ) — U.S.-traded ETF gives exposure specifically to Eurozone countries, excluding the U.K.

Previous ETF reports

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• A tantalizing fixed-income alternative
• Latest crop of ETFs keeps up pressure on fees