ETF Insights Report – iShares Core MSCI EAFE IMI ETF – TSE:XEF

iShares Core MSCI EAFE IMI ETF – XEF.TO

XEF seeks to provide long-term capital growth by replicating, to the extent possible, the performance of the MSCI EAFE Investable Market Index, net of expenses. Under normal market conditions, XEF will primarily invest in securities of one or more iShares ETFs and/or international equity securities. XEF’s current principal investment strategy is to employ a Sampling Strategy. In addition to or as an alternative to this strategy, XEF may also invest by employing a Replicating Strategy, by investing in one or more iShares ETFs and/or through the use of derivatives.

Focus area	Score	★★★★★
Performance (CAGR)	13.3%	★★★★
Fees (MER)	0.22%	★★★
Volatility (Beta)	0.73	★★★★★
Distribution (Yield)	2.51%	★★★★
Valuation (Forward P/E)	14	★★★★
5-year earnings growth	3.3%	★★

Pros

Single-click exposure to equities outside of North America that would otherwise be difficult to own
Although the fund is international, the bulk of its allocation will be to developed countries with solid economies
Considering the exposure it gives investors, the fees are reasonable
One of the better performing international ETFs available to Canadian investors

Cons

International exposure is inherently riskier than North American exposure. Although the countries inside of XEF are primarily developed economies, regulatory risk still exists
International markets have significantly lagged North American ones for quite some time

XEF is one of the more popular international ETFs in the country. This is mainly because it is a low-fee, well-diversified fund that allows investors to invest in markets that would otherwise be difficult to access.

The fund is an index fund that tracks the MSCI EAFE Investable Market Index. The “EAFE” portion of the name represents Europe, Australia, and the Far East. The fund contains a wide variety of large, mid, and small-cap stocks. Instead of focusing on emerging markets, it focuses on developed markets.

This is a key differentiator over something like BMO’s Emerging Market ETF ZEM. Many investors assume that “emerging” and “international” are interchangeable words in the investing world. While most emerging market ETFs contain international stocks, we must understand that not all international stocks are from emerging markets.

“Emerging” refers to a smaller economy that is finally starting to grow and contribute to the global economy. A “developed” market, the countries XEF has exposure to are already well established globally and have strong economies. Emerging markets ultimately have more potential due to their ability to grow their economy faster. However, they also come with more risk and historically, returns have not been all that strong for emerging markets.

It is XEF’s goal to give investors exposure to these international developed markets to give them more diversification outside of North America.

Sector Risk	Low
Concentration Risk	Low
Geographical Risk	Medium
Liquidity Risk	Low

Although XEF invests more in developed markets, there is still added regulatory risk when it comes to investing outside of North America. When it comes to specific industries and market practices, international frameworks can be significantly different than those in North America.

If one is to invest in international markets, one needs to understand that regulatory risk can materially impact the returns from these stocks. Particularly in countries where political parties vary in stance dramatically, a shift in government policy or government regulations can impact certain sectors of the market. In addition to added regulatory and political risk, currency risk also exists.

Fluctuations in the currencies of the countries this fund invests in can impact returns. Although this exists with investors investing in stocks located in the United States, it is amplified further when it comes to international markets, as their currencies tend to be more volatile.

Another added risk is opportunity cost. Although it is never a guarantee moving forward, international markets have lagged the US for quite some time outside of the last year or so. An investor aiming to diversify their portfolio outside of North America may find their returns lagging behind a portfolio comprised of high-quality North American stocks.

This is why if you are going to invest internationally, one must figure out a comfortable allocation percentage relative to their risk tolerance. This is going to be different for everyone, so it’s important you don’t rely on the standard blanket assumptions many pundits make.

Top 10 Holdings	Allocation
ASML Holding NV (ASMLF)	1.38%
SAP (SAPGF)	1.36%
Novo Nordisk (NONOF)	1.3%
Roche Holding (RHHVF)	1.17%
AstraZeneca PLC (AZNCF)	1.14%
Novartis (NVSEF)	1.07%
Shell PLC (RYDAF)	1.05%
HSBC Holdings (HBCYF)	0.98%
Siemens AG (SMAWF)	0.95%
Toyota Motors (TOYOF)	0.89%

This fund has 2400+ total holdings, which is why allocations even on the top side of the fund are relatively small. This adds an element of diversification and ensures that the struggle of a single company won’t really have a material impact on the portfolio.

As you’ll see, many of the top names are recognizable, unlike many emerging market ETFs. You’ll see major global corporations such as Novo Nordisk, which is a popular insulin producer, ASML Holdings, a semiconductor play, and even an automotive manufacturer such as Toyota.

I like the blue-chip nature of the top end of this fund, and it is relatively well rounded in terms of allocations as well. Financial services and industrials make up most of the portfolio, coming in at 18%~ allocations each, and more than 80% of the fund is allocated to large-cap stocks.

Although this is a fund that does mention it gives investors exposure to small and mid-cap stocks as well, they’re relatively small in weighting. Only around 16% of the portfolio is mid-cap stocks while 4% is small caps.

	XEF	EFG	ZEM
Returns	✅
Diversification	✅
Fees	✅
Tax efficiency	✅
Distribution	✅

In my opinion, I believe XEF is one of the best funds on the market today for diversified international exposure to developed markets. As you’ll notice, I’ve included BMO’s ZEM in this comparison despite it being an emerging market fund, not a developed market fund.

I did this primarily to highlight the difference between an emerging market ETF and a developed market ETF. The additional regulatory risks along with the added risks of investing in emerging economies are present in the chart above when you look at ZEMs returns.

EFG’s more concentrated approach (400 holdings versus 2600~ for XEF) along with higher exposure to international technology companies has really hurt it in terms of overall performance.

In my opinion, the less we know about a particular market, the more diversified we should be. In this case, many investors simply don’t know enough about the global markets to take a more concentrated approach, so I like the diversified nature of XEF much more than EFG.

Could a concentrated portfolio of international equities outperform moving forward? Certainly it could. However, there is the possibility it continues to struggle in the future and I would personally feel more comfortable grabbing a wide range of options with XEF.

I’ll speak more on the tax efficiency of the ETF in the distribution section next.

Yield	2.5%
Frequency	Semi-Annually

XEF yields in the mid 2.5% range, which is a relatively attractive yield for income seekers. Sure, it’s not as high as some popular Canadian dividend ETFs, but it’s not as low as a broad-based S&P 500 ETF.

The one important thing to note about the distribution is that it will be taxable, for the most part, in the form of foreign income. This makes sense, as the fund is filled with foreign companies. There are some capital gains in the distribution, but they vary depending on what the fund does in terms of rebalancing and such.

Historically, the fund’s distribution has been around 85% foreign income. If you have this in a taxable account, the foreign income isn’t the most optimal from a tax perspective, but also, shouldn’t be a deal breaker. International exposure is what we are aiming for here, not tax-efficient distributions.

The debate as to whether or not investors truly need international exposure will be one that is never finished. Many investors utilize portfolios of 100% North American equities due to the lower-risk environment in terms of regulatory risk and currency risk.

However, there is no doubt that international equities are attractive relative to US equities, primarily based on lower valuations. Although the US markets have dominated international ones in terms of overall returns, there is no guarantee it will continue. There is zero doubt you are getting a much better bang for your buck internationally than in the United States. The difficulty is primarily in determining whether or not investors will continue to pay the premiums to own US equities or if capital will flow into international markets because of these discounted valuations.

The decision as to whether or not you want to own international equities is not one I can make for you, unfortunately. However, if you do make the decision you want exposure to these markets, I believe XEF is one of the best funds in the country to do so.

Fees are low, the fund is well-diversified and has been one of the best performing in the country. If one were a bit more savvy when it comes to the international markets, they could isolate their exposure to single countries (Japan, China, Europe, Australia etc.), as there are certainly funds available for that, but I feel most investors would find it more suitable to just buy a large chunk of the international markets in a single click.

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