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ETFs That Take Some of the Volatility Out of Foreign Stocks

Currency-hedging and low-volatility approaches might make it easier to stick with international stocks over the long haul.

Alex Bryan, 08/31/2016

Low-cost, market-cap-weighted index funds can serve as the foundation of a strong portfolio. They effectively represent the collective views of all investors in a given market and should serve as a default for those who don't have an alternative opinion to express. Vanguard Total Stock Market ETF VTI (which charges a fee of 0.05%), Vanguard FTSE Developed Markets ETF VEA (0.09%), and Vanguard FTSE Emerging Markets ETFVWO (0.15%) are among the cheapest options for broad market-cap-weighted exposure to U.S., foreign developed-markets, and emerging-markets stocks, respectively. These three exchange-traded funds cover the full market-cap spectrum of their target markets and could form the nucleus of an equity portfolio. Foreign stocks tend to be riskier than their U.S. counterparts because they expose investors to greater currency risk. However, they should carry a significant weighting in a well-diversified portfolio.

Using the composition of the FTSE Global All Cap Index at the end of July 2016 as a point of reference, U.S. stocks represent 53% of the world's investable market capitalization. The corresponding figures for foreign developed-markets and emerging-markets stocks are 39% and 7%, respectively. Those who want to maintain a neutral regional allocation could use a fund like Vanguard Total World Stock ETF VT. But there are some advantages to retaining control over regional allocations rather than letting them fluctuate with market prices. This approach allows investors to maintain a more consistent level of portfolio risk (as stocks in each region have different risk characteristics) and rebalance opportunistically to take advantage of attractive valuations.

Because currency fluctuations tend to make foreign stocks more volatile than U.S. stocks, it is understandable that many U.S. investors choose to underweight them. During the past decade, currency movements accounted for nearly a fifth of the total volatility of the foreign developed-markets stocks in the MSCI EAFE Index. A strengthening dollar detracts from foreign stock returns, while a weakening dollar can provide a tailwind. These movements are tough to predict, and over the long term, they often don't have a huge impact on returns, but they can make foreign stocks tougher to own.

Currency Hedging
A currency-hedged fund, such as Deutsche X-trackers MSCI EAFE Hedged Equity DBEF(0.35%), could make foreign stocks easier to own. This fund invests in large- and mid-cap stocks in developed markets overseas and uses currency forwards to hedge its currency exposure. Currency hedging has put DBEF's volatility on par with U.S. stock funds, like VTI, and improves performance when the U.S. dollar strengthens.

It is important to note that currency hedging does not protect investors from expected changes in currency values. If interest rates are higher in the foreign market than in the domestic market, the forward price should be lower than the spot price such that the effective risk-free return should be the same in both markets. This is a condition known as covered interest-rate parity. While interest-rate parity doesn't always hold in the spot market, arbitrage enforces this condition in the forward market.

For example, if the risk-free interest rates in Australia and the United States are 4% and 1%, respectively, and the current spot price of the Australian dollar is 1.0 AUD/USD, the one-year forward price should be 1.03 [1.0*((1+.04)/(1+.01))]. If the forward rate were lower than this (say, 1.01), investors could borrow in the U.S. at 1%, convert U.S. dollars into Aussie dollars at the spot rate, invest at the Australian risk-free rate (4%), and sell forwards to hedge out the exposure. At the end of the year, the investor would convert AUD 1.04 to USD at 1.01 (USD 1.03), return USD 1.01 to the lender, leaving a USD 0.02 risk-free profit, with no upfront cash outlay. While the market is not perfectly efficient, it generally doesn't present this type of free lunch.

As a result of covered interest-rate parity, higher foreign interest rates generally increase the cost of hedging. Over the trailing 10 years through July 2016, the effective cost of hedging the MSCI EAFE Index (before taking fees and taxes into account) was actually a negative 48 basis points annually. This is measured as the difference in the return on stocks in the MSCI EAFE Index in their local currencies and the return on a hedged version of the index. In contrast, it cost 176 basis points annually to hedge the MSCI Emerging Markets Index. Because interest rates are currently higher on average in emerging markets than in developed markets, it is generally more expensive to hedge currency exposure there.

Hedging can increase costs in other ways, too. In addition to the higher fees that currency-hedged funds charge, currency hedging tends to reduce tax efficiency. That's because hedged funds must regularly roll their contracts forward to maintain the hedge, which can trigger taxable capital gains. For example, DBEF and Deutsche X-trackers MSCI Emerging Markets Hedged Equity DBEM (0.65% expense ratio) both made capital gains distributions in the past five years. In contrast, iShares MSCI EAFE EFA and iShares MSCI Emerging Markets EEM, which offer unhedged exposure to the same indexes, did not make any distributions during that time. Those who can stomach the extra volatility and have a long investment horizon may be better off leaving their foreign-currency exposure unhedged. 

Low-Volatility International-Equity Options 
Hedging currency risk isn't the only way to reduce the risk of investing in international stocks. Investors can also accomplish this with funds that tilt toward defensive foreign stocks, such as iShares Edge MSCI Minimum Volatility EAFE EFAV (0.20% expense ratio) and iShares Edge MSCI Minimum Volatility Emerging Markets EEMV (0.25% expense ratio). EFAV attempts to construct a low-volatility portfolio by selecting stocks from the MSCI EAFE Index. To do this, it uses a constrained optimization approach that takes into account individual stock volatilities as well as the correlations among them. The constraints limit the size of individual positions and the fund's sector and country tilts relative to the MSCI EAFE Index. EEMV follows a similar approach in emerging markets.

So far, EFAV has accomplished what it set out to do. Since its inception in 2011, this fund exhibited nearly one fourth less volatility than the MSCI EAFE Index. In fact, its volatility was comparable to VTI's, despite its unhedged currency exposure. EEMV exhibited a similar reduction in volatility relative to its parent benchmark, though not surprisingly, it was still more volatile than VTI. 

  

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please clickhere for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

 

Alex Bryan is an ETF analyst with Morningstar.

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