European equities hit five-year highs in January 2014 – but in view of the even more impressive performance and, some would say, stretched valuations in the US, continued interest from investors is likely. To invest in European equities might seem a deceptively straightforward decision to make. But what exactly constitutes Europe? Football’s UEFA includes Kazakhstan, and Israel has won the Eurovision Song contest three times – but neither country would be part of the average European equity mandate.

Does the question matter? For highly active, concentrated portfolios, probably not. But for investors seeking broad exposure to Europe, the answer could determine much of what they get exposure to. As Ursula Marchioni, head of ETP research EMEA at iShares finds, investors are increasingly giving themselves the option to adjust weightings to specific countries.

This can apply to active mandates as well as passive. “We have a client who specifically asked us to exclude Russia for governance reasons, even though it is in the benchmark, and replace it with Israel – which we ignore, as pushing into the Levant is a bit beyond our comfort zone,” says Andrew Parry, CEO of Hermes Sourcecap.

So what is the nature of the question? There is clearly considerable sector variation across individual countries and some countries are dominated by just a few individual stocks. Nestlé, Roche and Novartis account for over 52% of Switzerland’s equity market and healthcare accounts for 44%; Banco Santander, BBVA and Teléfonica account for more than 53% of the Spanish market, financials almost 50%; CRH, Kerry Group and Bank of Ireland account for over 57% of Ireland and materials 38%; Sweden is dominated by financials, with over 32% of the market in Nordea, Swedbank, Svenska Handelsbank and SEB, and industrials, with the likes of Volvo and Atlas Copco taking up 27%. Germany and France are more diversified, with no single sector accounting for more than 22%, but the top 10 stocks in Germany still account for over 59% of the market compared with 49% in France and 51% in the UK, in large-caps.

The most glaring example of a single country that makes a difference to European equity exposures is the UK, with a market-cap weight of nearly 33% in the MSCI Europe index. France is the next largest, at 14.8%. What does that country weight mean for a Europe exposure? BP, Shell and BG give the MSCI UK Large-cap index a high energy weighting of 19% (in MSCI Europe ex-UK it is 5.7%). It also has a high exposure to telecoms (9.9%, versus 4.9% for MSCI Europe), thanks to Vodafone. The flipside is large underweights in industrials and healthcare – the UK’s GlaxoSmithKline and AstraZeneca don’t quite balance out companies like Roche, Novartis, Sanofi and Bayer, all among the 10 largest European companies outside the UK.

Does this mean the UK should be treated separately from the rest of Europe? Certainly among UK investors, as recently as 2010, 44% of equity exposures was in UK equities, according to Hugh Cutler, head of Europe and the Middle East at Legal & General Investment Management (LGIM). But it is not only UK clients who see the UK as a separate allocation.

“Some German investors look at the UK as a separate allocation, while US investors, by contrast, look at the UK within the context of pan-European mandates,” Cutler says, adding that interest in standalone UK equities from non-UK investors tends to be focused on small-caps.

Another way of thinking about investing across European equity markets is to look at the underlying economic exposures each stock market would give an investor. Figure 1 shows the huge variation in domestic economic exposure, and the geographic spread of exposures, of Europe’s stock markets. But even these broad figures hide many significant variations and subtleties.

“We know that Germans buy lots of German cars and the French buy French cars,” say Daniel Hemmant, portfolio manager at BNP Paribas Asset Management. “But the profitability of BMW and VW is far more geared to what is happening in China. Why? Because there they sell fully-loaded 7-series BMWs, so while volumes are low profitability is very high. In contrast, French manufacturers sell largely in Europe.”

Let’s switch this around to sectors. Europe’s utilities, telecoms and financials are the most domestically-focused businesses, while its healthcare, IT and materials companies are the most international. Healthcare has a high exposure to the US, while IT and materials are the most exposed to emerging markets.

Hemmant points out that, over the past few years, companies with international exposures have done well relative to domestically-focused companies. This performance overlaps the success of growth stocks versus value. Value, unsurprisingly, is found in places no one really likes – in other words, for the past five years, Europe. In sector terms, as we have seen, that means financials, telecoms, utilities and retail. These have enjoyed a resurgence more recently as value investors have taken charge of sentiment in Europe, re-rating sectors that have looked quite depressed and have dragged the overall returns on equity of the market to historically low levels. If you assume these will continue to recover, that might influence the countries to which you want to increase exposure, for example.

While many of the variations in economic exposures are simply stock-specific, some can also be attributed to the legacy of history. The UK and the Netherlands, for example, have many international companies built up from their imperial days, often with high exposures to emerging markets. Austria’s high exposure to Eastern Europe is rooted in history of the Austro-Hungarian empire, while parts of southern and eastern Europe have long-standing religious and cultural ties with Greece dating back to the Byzantine empire. However, Portugal, despite its imperial history, has the highest domestic exposure of any country in Europe at 56%.

Perhaps more interesting are the smaller countries, such as Switzerland, Finland, Ireland and Sweden, which host some very large international companies.

“We find it straightforward to find good companies in Switzerland and Scandinavia,” says Jeremy Whitley, head of UK and European equities at Aberdeen Asset Management. “They had to go overseas as their local populations were too small. Over the years, these companies had to compete in global markets so they tend to be very good in niche areas.”

Good examples are found in the elevator industry, he explains, which is dominated by Otis in the US, Schindler in Switzerland, Germany’s Thyssen and Kone in Finland. “Technologically they are very advanced and had always had to compete overseas,” he observes.

That might be why there are three in Europe (and they have been around for over a hundred years) and only one in America: US companies have not been under the same pressure to compete overseas, thanks to their very large domestic market, and have not enjoyed the networks gained through empire. “Proctor and Gamble could not compete as well as Unilever in Indonesia, for example,” Whitley suggests.

Some of these historic patterns account for the fact that investors tracking the MSCI EMU index rather than a Pan-Europe index – and therefore not getting the UK, Switzerland and Sweden – end up with much less economic exposure outside Europe. Perhaps it is not surprising that iShares sees increasing interest from clients in using the MSCI EMU index plus individual countries – broadly replicating MSCI Europe but with the ability to overweight or underweight specific countries.

“In 2013 we saw periods where our single-country German ETF was popular and we tend to see this kind of interest when the markets rally,” notes Marchioni.

These issues of underlying economic exposures are also clearly significant if an investor is thinking about going over or underweight a particular country. Some would now regard France as a compelling value opportunity, for example – but while Gavin Launder, head of European equities at LGIM, is bullish on the country, finding the right domestic companies has proved a challenge.

“We have avoided utilities, telcos and energy as they face, respectively, government interference, competitive pressures and a drifting and declining oil price,” he says. “French banks are not particularly focused on France – Crédit Agricole is the most liquid of the domestic banks but had a large exposure to Greece, for example. The car manufacturers sell throughout Europe, and investing in French retailers such as Carrefour also involves an overseas bet.”

And the same goes for other countries, too. Launder has wanted to buy Germany over the past couple of years but again found it difficult to find listed, pure-play domestic stocks.

“TV broadcasters are the closest,” he says. “Even the retailers are largely exposed to eastern Europe. The only other option is mid-sized banks – but actually they are full of southern European bonds.”

Putting all of this together, what are the key choices facing investors who want to invest in Europe’s equity markets?  

The first is whether to include emerging Europe. LGIM’s predominantly UK client base tends to treat emerging Europe as part of global emerging markets allocations, so it does not offer a pan-European product that includes those markets. By contrast, Hermes Sourcecap sought to have as few constraints as possible for its flagship European fund, so its preferred benchmark is the FTSE All World Europe index, which includes countries like Hungary and the Czech Republic.

“We deliberately chose this benchmark because it has the broadest European exposure, even though we currently have a bias towards northern Europe and limited exposure to peripheral markets,” Parry explains.

Investors that are focused on developed markets alone are then faced with the option

of adopting either a pan-European approach (and that with or without the UK), or a euro-zone-only approach. The MSCI EMU index has just 10 countries against MSCI Europe’s 15 (which include the UK, Switzerland, Sweden, Denmark and Norway). For active managers, the choice of benchmark can have a significant influence.

“We went to Greece recently and found that it has made a good recovery and a number of companies are doing well,” says Whitley at Aberdeen. “Some companies in Spain also look interesting. These can make it into our Europe ex-UK fund but not our pan- European strategy, as they would be edged out by more attractive UK companies.”  

Where investors find themselves in relation to these choices often depends upon how far along they are in evolving from their legacy domestically-biased equity portfolios towards something more geographically diversified.

“Twenty years ago most Dutch pension funds invested purely in Dutch equities,” recalls Peter  Ferket, equity CIO at Robeco. “[Since then] the path has been from local, to regional, then global, and finally including emerging markets.”

Even 10 years ago, Robeco saw clients with a stronger bias towards pan-European than global allocations, and sometimes even just euro-zone allocations.

“One element that has changed is the fear over currency risk associated with international investing,” says Ferket. “That gave the rationale for using a euro-zone index. Now the ability to hedge gives the choice of investing on a hedged basis and we hedge exposures to global equity markets back to euros.”

Nowadays, Ferket says that demand for euro-zone benchmarks is non-existent among Dutch institutional clients – and indeed throughout Europe, with the notable exception of France.

“French clients are very much focused either on the euro-zone, or global,” he observes. “Our experience in France is that they move first from French equities, then to euro-zone, and then on to global, whereas clients in the Netherlands, for example, move straight from Dutch equities to pan-European and then global, without the euro-zone in the middle.”

Other asset managers find a similar pattern – sometimes attributing it to the PEA tax wrapper for retail investors that was extended from France-only to the whole euro-zone in 2001 – while also reporting significant demand for euro-zone-only product in Germany and Belgium.

Investing in European equities is much more complex than it seems at first. Most individual countries are too small to be considered as separate investment destinations but, at the same time, what constitutes a natural collection of countries for a regional investment strategy is not straightforward – not least because this region has seen its political boundaries re-arranged countless times, and its cultures and companies grow to reflect empires and interests that once spanned the globe.