How First-Quarter Volatility Hit Foreign Stock Funds

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Christine Benz: Hi. I'm Christine Benz from Morningstar.

The slide in the U.S. market has dominated headlines, but the performance of foreign stocks has gotten less attention. Joining me to provide a recap of the first quarter for foreign stock funds is Dan Sotiroff. He's an analyst in Morningstar Research Services.

Dan, thank you so much for being here.

Dan Sotiroff: Hey Christine. You're welcome. Thanks for having me on.

Benz: Let's talk about foreign stock fund performance in the first quarter. Oftentimes when the U.S. market is down, foreign stock funds are down more. Was that the case recently?

Sotiroff: Yeah, it's done a lot of the same. The performance, like you said, has been actually a little bit worse, and there's reasons for that, obviously. When you look at foreign stocks, you have to remember there's two components to this. There's the local stock returns, and there's the currency aspect of it. If we just talk about local stock returns, yes, the local stock returns were a little bit worse, and than that currency component really accelerated as the market went into a decline. Obviously, there's sort of this flight-to-safety aspect. People want U.S. Treasuries and other sovereign bonds that are a safe holding period, so currency has certainly weighed on it as well.

Benz: Let's talk about some of the hardest-hit markets. You say Europe suffered particularly stark losses during this period.

Sotiroff: European stocks are obviously a major component of broader foreign indexes and the funds that track them, so they have a pretty big say in the performance of foreign markets broadly. When you look at the composition of foreign markets in Europe, they're much more heavily weighted in financial stocks and energy stocks, and both of them have been hit pretty hard. Financial stocks--when central banks around the world are cutting interest rates to try and stimulate the economy, that tends to have the effect of flattening the yield curve. And banks are in the business of borrowing short and lending long, so whenever the yield curve flattens, that spread that they pull their profits from tends to evaporate or at least decline. That's one aspect of it.

The other aspect of it is it looks like we're probably going to be heading for a pretty big recession here. And as we get into this recession, if it does indeed come, businesses and individuals obviously they're probably going to have a hard time paying the interest on their loans. So that's another source of revenue for these banks that tends to dry up a little bit. So they're obviously going to get hit pretty hard.

The other side of it is really energy stocks as well, which are more heavily weighted in foreign markets. You've seen a couple things happen there. First, as this virus has started to spread, people are traveling a lot less, so there's reduced demand for oil and petroleum products in general. The second aspect of it, as you've probably seen this price war between OPEC nations and Russia really kind of take on a pretty meaningful cut in oil prices as they're pumping up supply.

Both of those things collectively have weighed on energy companies, and it's had a pretty big impact already. Oil is now trading at below $20 a barrel as of yesterday. Those are prices we haven't seen in almost 20 years, so it's having a pretty big impact.

Benz: Now, how did the dollar do relative to major foreign currencies during this time? You hinted for foreign stock investors that's part of the equation in terms of their returns. Did the hedged products, the hedged ETFs, for example, outperform the funds that have full exposure to foreign currencies?

Sotiroff: They did. Hedge funds have worked. They've delivered on what they were supposed to do, which is, first and foremost, get rid of the additional volatility from most foreign exchange rates. But also when you're in an environment when the dollar is appreciating, it helps you out. You don't have that additional currency component weighing on your returns. So they've generally delivered as you would expect.

Probably the one caveat there is really been with Japan because Japan tends to be this center of safety as well. The Japanese yen has really not done a whole lot, though returns from the Japanese market, hedged or unhedged, have been roughly equal. So not a lot of gain in Japan, but Europe, eurozone, those sorts of currencies, definitely hedging worked.

Benz: How about another strategy that investors sometimes use to hedge out risks, which is the low-volatility strategies? How did they do overseas during this period of turbulence?

Sotiroff: They've genuinely done pretty well, and they've done exactly what we would expect them to do. For starters, they're really supposed to take volatility out of the long-term returns, but over shorter periods, when you go through these stressful market periods, what they can do is they can help reduce drawdowns. They sort of dampen the blow. What's really important to remember is that they are risk assets. You're still holding stocks, so they're going to decline. They're just not going to decline as much as their representative markets. What we've seen is you've generally been about 5% to maybe 7% better than the broader market, which is in line with what we've seen in the past during major market drawdowns from these funds. So they've held up pretty well.

Benz: What are some practical takeaways for investors in foreign stock funds and ETFs after this recent downswing?

Sotiroff: I think the same kind of rules of thumb apply to foreign stocks as they do to just any broader investment. First and foremost, stick to your plan. If you have a rebalance, go ahead and rebalance. If not, hang tight until you get to that rebalancing point, whether that's based on drawdowns or whether it's based on just the end of year or end of quarter, end of June 30, whatever it is, stick to your plan, first and foremost.

The other big thing that I've been talking to people about is when you get into these really stressful events, it's really an opportunity to reassess your risk tolerance. Did you handle this OK? Did you get scared and you wanted to sell out of something? Those are indicators of what your risk tolerance is. If you didn't do too well with this, if this was uncomfortable for you, maybe in the longer term think about scaling back. Maybe taking a little bit of less foreign exposure than you had in the past because they do tend to be a little more volatile. Part of it is the currency exposure that you have, so you can cut volatility back by scaling back on your foreign stocks.

But really keep the longer term in mind with all of this. We go through these things every once in a while, but they tend to pass over time. So stick to your plan, rebalance, and think about your long-term risk tolerance.

Benz: Dan, it's always great to get your perspective, especially in difficult times like right now. Thank you so much for taking the time to be with us today.

Sotiroff: You're very welcome. Thank you Christine.

Benz: Thanks for watching. I'm Christine Benz from morningstar.com.