Foreign Stock Investments --- Currency Hedged Or Not?

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Foreign Stock Investments — Currency Hedged Or Not?

Two years ago, we discussed currency-hedged ETFs in our February 1, 2022 newsletter: Foreign Stocks And Global Asset Allocation. At the time, we noted that the currency effect significantly impacted the returns of foreign stock ETFs such as Vanguard’s international stock ETF (VEA, or EFA) and emerging markets stock ETF (VWO or EEM). In this newsletter, we will delve deeper into this topic.

Background on currency-hedged international and emerging market stock ETFs

Currently, the most popular currency-hedged ETFs are the following two ETFs:

ETF	Total Assets	Expense
EFA (iShares MSCI EAFE ETF)	52.8B	0.33%
HEFA (iShares Currency Hedged MSCI EAFE ETF)	6.7B	0.35%
EEM (iShares MSCI Emerging Markets ETF)	17.7B	0.7%
HEEM (iShares Currency Hedged MSCI Emerging Markets ETF)	159.6M	0.7%

From the above, we can observe that HEFA has a slightly higher expense ratio than EFA. Additionally, it has a substantial total assets figure of $6.7 billion. Generally, ETFs with higher total assets exhibit greater liquidity, resulting in smaller bid and ask spreads or trading costs. Conversely, HEEM possesses significantly lower total assets under management, despite sharing the same expense ratio as EEM. Furthermore, HEEM registers much lower daily average volume at 33K.

Let’s delve into the role of currency in international stock and bond investing.

When you invest $100 US dollars into an ETF without a currency hedging mechanism, such as EFA, the fund managers receive your US dollars and must purchase various underlying stocks held in the ETF, like Denmark’s ‘Novo Nordisk A/S Class B’ priced in local DKK (Danish Kroner) currency, which comprises 2.55% of EFA. Consequently, the fund managers need to exchange $2.55 to DKK to acquire the equivalent Novo stock in DKK. Similar currency exchanges must occur to purchase other stocks in the ETF.

As the ETF lacks currency hedging, its valuation is influenced by real-time exchange rates of the US dollar and the local currencies involved. This is crucial because when you eventually sell your EFA holding, the managers must sell those stocks in local currencies and then exchange them back to US dollars.

The exceptionally strong performance of the US dollar since 2010 has significantly impacted EFA’s returns in US dollars. For instance, when you bought EFA in 2010, merely the devaluation of local foreign currencies would account for more than 20% based on the following US dollar chart (the DXY US dollar index represents the US dollar exchange rate against a basket of foreign currencies):

On the other hand, HEFA, which is a currency-hedged version of EFA, employs currency forward contracts to mitigate fluctuations in local currencies against the US dollar. These contracts are typically rolled or adjusted on a monthly basis. As of 3/31/2024, HEFA holds the following major currency forward contracts (see iShares fund fact):

The cost of currency hedging is included in the fund’s transaction expenses, which are not reflected in HEFA’s 0.35% expense ratio. This cost has an impact on the fund’s overall returns. Fortunately, the expense of hedging major currencies has decreased significantly over the years.

Latest currency-hedged ETF returns

Let’s take compare the latest ETF returns (as of 5/3/2024):

ETFs	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	15Yr AR	20Yr AR
EFA (iShares MSCI EAFE ETF)	4.7%	11.5%	3.0%	6.4%	4.5%	7.3%	5.6%
HEFA (iShares Currency Hedged MSCI EAFE ETF)	10.2%	19.8%	11.0%	10.6%	8.9%
EEM (iShares MSCI Emerging Markets ETF)	5.6%	13.1%	-5.5%	1.5%	2.4%	4.7%	6.5%
HEEM (iShares Currency Hedged MSCI Emerging Markets ETF)	7.8%	15.6%	-2.7%	3.5%
VTI (Vanguard Total Stock Market Index Fund ETF Shares)	7.3%	27.1%	6.8%	12.8%	12%	14.4%	10.1%

Note that HEFA’s inception date is 02/14/2014 while HEEM’s is 09/25/2014. Just about 10 years that span over the strength of US dollars.

Indeed, non-currency-hedged ETFs have significantly underperformed their currency-hedged counterparts. While HEFA still lags behind the US stock index fund VTI, the performance gap has become more reasonable. Interestingly, HEFA has outperformed VTI over the past three years.

Hedged or not hedged: returns and risk

The preceding discussion provides only a brief overview of the history (10 years) since the introduction of currency-hedged ETFs. Morningstar has published an excellent article that delves into a more detailed discussion on the risks and returns of currency-hedged and unhedged ETFs. Below, we present two main charts and tables from that article:

The chart above indicates that since 1980, the difference in annual returns between hedged (in local currencies) and U.S. dollar (non-hedged) ETFs is not very significant in the aggregate, although the local currency one (hedged) shows slightly higher returns. It’s important to note, however, that since 1980, US dollars have experienced three major bull markets and two major bear markets, as highlighted in the first chart of this article.

The following table clearly illustrates that the unhedged (i.e., EFA) ETF has a higher standard deviation. This is further corroborated by MyPlanIQ’s data for maximum drawdowns and standard deviations.

Intuitively, it makes sense that the unhedged EFA has higher volatility, as its returns are not only influenced by its holdings’ volatility but also by currency exchange rates. Therefore, the unhedged ETF carries an additional risk factor: currency exchange risk.

The takeaway

Our takeaway from the above data is as follows:

Returns: we don’t concur with Morningstar’s assertion that in the long term, currency exchange risk tends to be minimal. In reality, nobody can predict currency exchange directions, even over an extended period. Currency exchange rates are determined by several major factors, such as the long-term strength or weakness of regional economies compared to the U.S., as well as international or geopolitical policies, among other local developments. However, from the US dollar historical chart, one can see that currencies usually go through some major ups and downs, which could potentially be taken advantage of by a tactical investment strategy.
Risks: as stated above, it’s clear that unhedged ETFs do have higher volatility.

Synthesizing from the above observations, we advocate the following

For strategic asset allocation (buy and hold) portfolios, it’s beneficial to utilize currency-hedged ETFs. This not only eliminates the additional currency exchange rate risk factor but also could truly increase diversification effects. Even with the added currency hedging cost, we believe it’s worth consideration. Certainly, we advise caution as the US dollar bull market has persisted for an extended period, raising the possibility of its imminent end. However, despite the lack of clear indicators suggesting an immediate downturn, it’s essential to adhere to the principles of strategic allocation portfolios, which advocate against being influenced by personal biases or short-term market fluctuations.
For tactical asset allocation, adding currency-hedged ETFs as additional candidate funds can help boost returns while reducing risk.

As a side note, it’s worth pointing out that even for those concerned about a secular decline in a particular economy (some, for example, believe Japan is in a secular decline, a topic subject to debate), as we’ve emphasized many times before, strong and reputable companies have the potential to thrive and reap benefits even in such conditions. This holds as long as financial markets remain fair and transparent. Indeed, investing in stocks denominated in local currencies can potentially yield returns comparable to those in one’s home country.

We are in the process of modifying our strategies to include currency-hedged funds as candidate funds.

Market Overview

According to Factset’s data as of May 3, 2024, S&P 500 companies, with 80% of them having reported actual results, recorded a 5% blended earnings growth for Q1 2024. This surpasses the 3.4% expectation expected on March 31, 2024, indicating that concerns about an earnings slowdown were unfounded.

Conversely, April’s nonfarm payrolls saw an increase of 175,000, significantly lower than the Dow Jones consensus estimate of 240,000. Additionally, the unemployment rate climbed to 3.9%, compared to the previous year’s rate of 3.4%. The weakness in employment serves as a clear indicator of an economic slowdown. However, this perceived negative development turned out to be positive news for investors, as it raised expectations of a higher likelihood of interest rate cuts by the Federal Reserve in the coming months.

As always, we claim no crystal ball and we call for staying the course which is guided by the well defined and sound strategic and tactical strategies:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as we have emphasized numerous times when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years, preferably much longer, given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially during this time. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This is true time and time again.

Stock valuation has dropped, and now valuation is becoming less hostile. However, it is still not cheap by historical standards. For the moment, we believe it’s prudent to be extra cautious. However, how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of market is through dollar cost average (DCA), i.e., invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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