ETF Specialist

Foreign Diversification Without the Currency Risk

Daniel Sotiroff

Foreign stocks bear an additional layer of risk stemming from changes in foreign-exchange rates, making them more volatile than their U.S.-listed counterparts. But currency-hedged international-stock funds allow investors to benefit from global diversification without taking on extra risk. Currency-hedging won't always help performance and could hurt tax efficiency, but it should consistently reduce volatility.

 IShares Currency Hedged MSCI EAFE ETF (HEFA) has a few advantages over its competitors. Its diversified portfolio captures a large chunk of the available foreign market capitalization while also hedging currency risk. But similar unhedged portfolios are available for a fraction of the cost, limiting the fund's Morningstar Analyst Rating to Bronze.

The fund tracks the MSCI EAFE 100% Hedged to USD Index, which covers stocks from the MSCI EAFE Index while hedging currency risk. This benchmark includes large- and mid-cap stocks from 21 developed markets outside of the United States. While it does not capture the full breadth of foreign markets, it does provide a well-diversified portfolio that covers a majority of the available market cap. Stocks from emerging markets and Canada are excluded. Collectively, stocks from these regions represent about 10% of a typical peer's assets, so excluding them should not cause dramatic differences in long-term, Morningstar Category-relative performance.

Foreign stocks can be more volatile than a comparable portfolio of domestic stocks because they are exposed to changes in foreign-exchange rates. Over the long term, currency risk usually isn't well compensated, which can make currency-hedging attractive for those who would prefer to avoid the extra volatility. This fund uses currency forwards to hedge its currency risk, which should reduce its volatility relative to the unhedged MSCI EAFE Index. However, it can cause the fund's performance to deviate from its competitors'.

From its launch in January 2014 through December 2016, the fund outperformed 98% of its competitors because the dollar appreciated against many foreign currencies, benefiting a hedged strategy like this one. But the dollar subsequently depreciated in 2017, causing the fund's total return to fall to the bottom of the category for that year. Over long periods, currency movements tend to have little impact on total returns.

BlackRock charges a 0.35% expense ratio for this fund, making it cheaper than the 0.88% category average. However, similar index-tracking funds that cover foreign developed markets are available for substantially less.

Fundamental View
Foreign stocks account for 47% of total global market cap. While this fund's benchmark, the MSCI EAFE Index, is not the broadest representation of the foreign market, it does capture a majority of the available market cap listed outside of the U.S. and effectively diversifies stock, sector, country, and currency risks. This portfolio focuses on large-cap stocks, with major multinational firms like Nestle, Toyota, and BP among its top holdings. International corporations like these have global operations and diversified revenue streams, so they don't provide clean access to the economies where they are headquartered. This makes their country of listing less important. But foreign stocks still serve an important role in an investor's portfolio, as they can diversify a U.S.-centric portfolio.

Market-cap-weighted indexes like this one are cost-effective. Using this technique, a stock's weighting will float with changes in its price and require very little turnover in order to maintain its desired exposures. This approach essentially free-rides on the judgment of active investors. The weighting of a given stock or sector will be an outcome of their collective opinions about each stock's relative value. Low turnover translates into low transaction costs.

This approach can also be effective at diversifying stock-, sector-, and country-specific risks. Despite omitting emerging markets, this fund's sector composition closely resembles the category average. The financials sector accounts for the largest slice of this portfolio and the category average, at roughly 20% of assets. Its wide reach also diversifies stock-specific risk better than many of its competitors, investing in more than 900 companies, with its 10 largest holdings accounting for only 11% of assets.

Market-cap weighting and the exclusion of small-cap stocks give the fund a larger market-cap orientation than most of its peers. Its average market cap is currently about one third larger than the category average. The fund's exclusion of small-cap stocks slightly reduces its diversification potential.

This fund's holdings include stocks from 21 different countries, exposing investors to a range of currencies, like the yen, pound, and euro. But the fund's managers use forward contracts to hedge the additional volatility that foreign currencies create. Over the long-run, this should lead to a stream of returns that exhibits less volatility than the unhedged MSCI EAFE Index. So far, this has been the case. From its launch in January 2014 through February 2018, this was one of the least volatile funds in its category. Its volatility during this period was mildly higher than the S&P 500.

Portfolio Construction
The fund tracks the MSCI EAFE 100% Hedged to USD Index. It combines a diversified, low-turnover portfolio with a reasonable currency-hedging strategy, earning a Positive Process Pillar rating.

The fund's selection process starts with stocks listed in 21 foreign developed markets and targets the largest 85% of this cohort by market cap. Buffer rules around the cutoff point are used to help reduce turnover. Qualifying stocks must also meet liquidity requirements to make the index easier to track and mitigate trading costs. Stocks that make the cut are weighted by market cap, which helps mitigate turnover and the related trading costs, since a stock's weighting will float with changes in its price. The index is reconstituted semiannually in May and November. It makes smaller adjustments during additional quarterly reviews in February and August, such as adding recent IPOs.

The managers use  iShares MSCI EAFE ETF (EFA) to track the stocks in this index and combine this with forward contracts at the parent portfolio level to hedge away currency risk. They roll these contracts over on the last day of each month.

Fees
The fund carries a 0.35% expense ratio, making it cheaper than 85% of its peers in the foreign large-blend category. It earns a Positive Price Pillar rating, but  iShares Core MSCI EAFE ETF (IEFA) includes small-cap stocks, doesn't hedge currency risk, and charges only 0.08%. Market-cap weighting modestly adds to this fund's cost advantage by mitigating turnover and the associated trading costs. The costs of hedging developed-markets currencies with forward contracts are generally low, typically running around 3 to 5 basis points annually. The fund must sell these contracts at the end of each month, which can trigger capital gains distributions. It made such distributions in 2014, 2015, and 2016.

Alternatives
 Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) tracks the same index as HEFA and charges the same 0.35% fee, making it a direct competitor. It also carries an Analyst Rating of Bronze.

IEFA is more compelling way to access stocks from the MSCI EAFE Index. It provides more-diversified coverage through its inclusion of small caps, holding more than 2,500 stocks with only 9% of assets in its 10 largest holdings. Its 0.08% expense ratio is competitive with the lowest fees in the foreign large-blend category, supporting a Silver rating.

Silver-rated  Vanguard FTSE Developed Markets ETF (VEA) (0.07% expense ratio) features a portfolio of developed-markets stocks that looks similar to IEFA, but it includes those listed in Canada and South Korea, giving it a mild diversification advantage. Like IEFA, its extensive reach also sweeps small caps into its portfolio.

Investors who are looking to reduce volatility but prefer to avoid the potential capital gains that come with currency-hedging might consider  iShares Edge MSCI Min Vol EAFE ETF (EFAV). This fund uses an optimization routine to select stocks from the MSCI EAFE Index that will create the least volatile portfolio possible, subject to several constraints. As expected, its historic volatility has been substantially lower than the foreign large-blend category average. It charges an expense ratio of 0.20% and has a Silver rating.

Daniel Sotiroff has a position in the following securities mentioned above: VEA. Find out about Morningstar's editorial policies.