ETFs That Take Some of the Volatility Out of Foreign Stocks

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.

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

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

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,

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

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.

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