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ETF Specialist

More-Palatable Approaches to Adding Foreign Fare to Your Plate

Foreign stocks can be riskier than their U.S. counterparts, but it is possible to mitigate this risk.

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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) (0.05%),  Vanguard FTSE Developed Markets ETF (VEA) (0.09%), and  Vanguard FTSE Emerging Markets ETF (VWO) (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 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 November 2015 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 40% 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.

There could also be good reasons for U.S. investors to overweight U.S. stocks. For example, U.S. stocks should serve as a better long-term hedge against U.S. inflation than foreign stocks. Currency fluctuations can also make foreign stocks more volatile, as a strengthening U.S. dollar detracts from their returns. During the past decade, currency fluctuations accounted for nearly a quarter of the total volatility of the foreign developed-markets stocks in the MSCI EAFE Index. Consequently, foreign stocks can be tougher to own.

Currency Hedging
One possible way of making foreign stocks easier to own is to hedge the currency risk with a currency-hedged fund, such as  Deutsche X-trackers MSCI EAFE Hedged Equity (DBEF) (0.35%). 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 November 2015, the effective cost of hedging the MSCI EAFE Index (before taking fees and taxes into account) was actually a negative 61 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 166 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, Deutsche X-trackers MSCI EAFE Hedged Equity 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. Under current tax laws, 60% of the gains or losses on these contracts are taxed at long-term rates, and the remaining 40% are taxed at less favorable short-term rates. 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 MSCI EAFE Minimum Volatility (EFAV) (0.20% expense ratio) and  iShares MSCI Emerging Markets Minimum Volatility (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 a quarter 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. 

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Alex Bryan has a position in the following securities mentioned above: EFAV, EEMV. Find out about Morningstar’s editorial policies.