European equities are often essential to a diversified portfolio—but which Europe are we talking about? The Europe of France, Germany, the U.K. and a dozen other industrialized nations that together constitute one-fifth of the world economy? The Europe of emerging markets such as Czechia and Hungary? Or the Europe of former Eastern bloc countries such as Estonia and Romania, now dubbed frontier markets because of their heightened risk to investors? (See “A tale of three Europes,” below.)
“The region can definitely diversify your portfolio,” says Jeff Kleintop, Schwab’s chief global investment strategist, “but in ways you might not expect.”
Rather than looking at Europe as a collection of macro economies, consider the continent’s countries through the lens of sector diversification.
“Germany, for example, has an export-oriented economy driven by the auto industry—so much so that the country’s main stock index, the DAX, tracks the MSCI World Automobiles Index almost perfectly,” Jeff says. And what’s true of Europe proves to be true of the U.S. as well—which is one reason international diversification by sector is so compatible with a broad portfolio of U.S. stocks. “Although we have a lot of sectors in the U.S., the S&P 500® Index moves pretty much in lockstep with the technology sector,” Jeff explains. “That’s worked out well in recent years but nevertheless needs offsetting. In the aftermath of 2000’s dot-com crash, for example, outperforming European stocks helped counter the domestic contagion of the tech sector.”
By the same token, investors should resist second guessing a specific stock based on the outlook for the country’s overall economy. “Individual economies don’t matter nearly as much as the sectors that drive their markets,” Jeff says.
How to invest
Investing in Europe gets you more diversification today than at any time in the past 20 years. Indeed, Jeff’s most recent analysis reveals that the degree to which the world’s biggest stock markets are moving in sync has fallen to its lowest levels since 1997 (see “Less in lockstep,” below).
For investors with a long-term focus, Jeff suggests starting with a broad-based, European developed-markets index fund—with one important caveat: “Not all funds are created equal, so make sure you know what you’re getting,” he says.
Specifically, some European developed-market indexes, such as the MSCI Europe Index, include U.K. stocks, while others, such as the MSCI EMU Index, do not. The distinction matters because of Britain’s vote to exit the European Union (EU). Will distributors and manufacturers continue to enjoy unfettered access to approximately half a billion consumers on the continent? Will Brexit affect investment flows, the labor supply and perhaps even property values?
Although U.K. stocks have suffered little thus far, there are signs that business spending is softening, Jeff says. And as the government races to finalize the details of its EU divorce by March 2019, the path ahead remains uncertain.
While broad exposure to European markets can be achieved without U.K. stocks, Jeff believes it’s too early to count out Britain just yet. “The key isn’t to abandon the country altogether,” he counsels, “but to adjust your allocation as the impact of Brexit gradually comes into focus.”
If you’re interested in European emerging markets, on the other hand, Jeff says it’s probably better to avoid Europe-only funds and instead consider a global emerging-markets index fund. Such funds are often geared toward Asia but usually contain some Czech, Polish and Hungarian equities as well. “This exposure to Asian companies can help balance out the more limited diversification provided by Europe’s emerging-market stocks,” he says.
Meanwhile, frontier markets are best left to institutional investors. “Because their exchanges are so miniscule, frontier markets often become the functional equivalent of investing in just one or two stocks,” Jeff says. “You end up with less diversification, which defeats your reason for turning to Europe in the first place.”