The U.S. dollar has been on a tear the PAST YEAR and a half, and this has certainly been a factor as U.S. stocks have trounced international stocks during that period. But international funds that hedge foreign currency against U.S. dollar movements have fared much better because they were effectively immunized against the surging dollar.
Not surprisingly, money has flowed into hedged international ETFs. This category, which barely existed five years ago, had $56 billion as of Dec. 27, 2015, according to Morningstar. It is now nearly 13% of total international stock ETFs.
Are such funds worthwhile? There’s more to it than meets the eye, and I ended my research with a strong conclusion.
GUARDING AGAINST CURRENCY FLUCTUATION
Most international stock funds are exposed to foreign currency fluctuations. Thus, a European stock fund would get a boost when the euro gains against the U.S. dollar, while facing a headwind when the euro declines. That factor alone explains much of why international stocks trounced U.S. stocks from 2002 to 2007 (when the dollar plunged) and have badly lagged since (when the dollar was strong).
Over the past several years, funds have been created that protect against foreign currency changes. They can use foreign currency futures or forwards to essentially hedge away nearly all foreign currency risk. Futures trade in public markets such as the CME Group, while forwards are merely private contracts arranged through the largest financial institutions that provide the same foreign currency risk mitigation, though the mechanics are quite different.
WisdomTree, the market leader in currency-hedged ETFs, uses rolling monthly currency forwards, according to Jeremy Schwartz, WisdomTree’s director of research. The table “Currency-Hedged International Stock ETFs” shows the 10 largest currency-hedged ETFs as of Dec. 31. The ETF giant iShares recently entered this space, yet Vanguard has stayed out, though it hedges its international bond fund (BNDX).
A critical point is that, in both futures and forwards, there is someone on the other side of the exposure.
That is to say, there is an equal amount of money hedging the dollar as the euro. Thus, neither will make money before costs and, in the aggregate, they will lose money after costs. Each pays a spread (the cost of hedging) and benefits by reducing risk.
THE CASE FOR HEDGING
Though we know that hedged international funds have trounced unhedged funds over the past couple of years, we also know that past performance is a lousy indicator of future results. Still, there are strong arguments for hedging.
For starters, there is a strong divergence in central bank monetary policies, with the Federal Reserve raising U.S. interest rates and the European Central Bank continuing quantitative easing, resulting in negative short-term nominal rates. Thus, the argument can be made that the U.S. dollar will continue to gain against the euro.
Next, the cost of hedging is very inexpensive. Schwartz argues that the costs of hedging against the Swiss franc, yen and euro are negative, meaning the investor is being paid to reduce risk. Hedging other currencies can be expensive, however, such as the Brazilian real at more than 10%.
I pushed back, saying that markets had already taken into account the predictions of a rising Swiss franc and plummeting Brazilian real. But Schwartz and the CME chief economist, Bluford Putnam, schooled me by pointing to research indicating that foreign currency futures were lousy indicators of future spot prices. I hate it when the facts don’t support my beliefs.
There is a second cost, however: the transaction costs of hedging. Both the CME Group and private banks profit from a spread on these futures. Putnam noted that foreign currency futures are the most liquid of any market. Schwartz estimated the annual transaction costs to be 2 or 3 basis points annually for the euro, but noted that other currencies could be far more expensive.
So, having made the case that hedging is inexpensive, Schwartz presented additional benefits. He stated that, from Dec. 31, 1969, to Sept. 30, 2015, hedging reduced the annual standard deviation of the MSCI EAFE index by 2.6 percentage points, from 17% to 14.4%.
According to Schwartz, not only has hedging reduced risk in the past, but it is likely to do so in the future. He notes that “correlations between currency and equity expressed in local terms would have to fall below minus 0.3 before currency would lower volatility of international equities.”
Thus, Schwartz advises us to ask this question: “Why am I taking foreign exchange risk in my international stock portfolio, when it’s easy and inexpensive to hedge it away?”
THE CASE AGAINST HEDGING
Before burying unhedged funds, however, I asked leaders at the industry giant Vanguard why they hadn’t jumped in on the recent surge of hedged international stock funds.
Paul Bosse, a principal at Vanguard’s Investment Strategy Group, says the only U.S.-based Vanguard funds hedging foreign currency are its international bond fund (BNDX) and the Global Minimum Volatility Fund (VMNVX). He pointed out that, in general, it didn’t pay to triple the costs of a fund when, before costs, it doesn’t impact the long-run expected return of the fund. Indeed, a Morningstar report by Patricia Oey places the unhedged EFA 25-year annualized return at 5.4%, versus the hedged at a smidgen less, at 5.1%.
Bosse says Vanguard hedged the bond fund to maintain the stable characteristic of a bond fund, and the international stocks within its global minimum volatility fund because minimizing volatility was the stated goal of that fund.
Bosse does acknowledge that hedging lowers the annualized standard deviation by two to three percentage points. But does that translate into better results from an overall portfolio perspective? The financial theorist William Bernstein notes that disciplined rebalancing in asset classes with the same expected return will give higher returns for the asset class with higher volatility, as long as the correlations are below 1.
So I went back to Schwartz, who was kind enough to backtest the long-run returns of a portfolio that was 40% U.S. stocks; 20% Europe, Australasia and Far East stocks; and 40% aggregate bonds. His results are shown in the “Annual Rebalance” table below.
The unhedged portfolio had a slightly higher annualized return but slightly lower risk-adjusted return, as measured by the Sharpe ratio. This result is consistent with Oey’s research showing “no significant difference in long-term risk-adjusted returns” in hedged or unhedged strategies.
The final two arguments against hedging are taxes and fees. The research assumed a world without taxes or fees.
In the real world, hedging has some tax disadvantages. According to Oey, gains from hedging are taxed as 60% long-term and 40% short-term. Losses, on the other hand, can only be carried forward.
In addition, hedged international funds are far more expensive. The simple average of the annual expense ratios of the 10 largest hedged funds is 0.48%, while broad unhedged international stock index funds, such as Vanguard Total Stock (VXUS) and the iShares Core International Stock ETF (IXUS), each have a 0.14% expense ratio. So, in the real world, hedging has 3.5 times the costs.
I have softened my position against foreign exchange hedging on international stocks. Mathematically speaking, the argument against hedging is strong, in that it’s likely to reduce long-run returns after expenses and taxes.
But we are not mathematical beings; we are emotional beings. So if the lower volatility in hedged international stocks results in less moving in and out of international stock funds, then it may well be worth the costs.
On the other hand, if it results in moving back and forth between hedged and unhedged funds, then the behavioral argument is also against moving your client to hedged funds. The fact that money is pouring into this relatively new class of funds is reason enough to use extreme caution. Following the herd is a strategy that I recommend against.
So I’m maintaining my position to not currency-hedge international stock funds and to avoid international bond funds. I recognize, though, that these are close calls.
In fact, even more important than where you come out on these is being consistent. Motion tends to decrease returns, as shown by countless studies. In this case, I think being consistent is more important than getting it right in the first place.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.
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