When it comes to buying international stocks, investors have a lot of decisions to make. Should you buy a broad exchange-traded fund or just play regionally? Maybe a single country? Developed or emerging markets? And depending on the country, you might even have different themes to choose from.
Well, there’s another option that investors need to decide on when it comes to buying international stocks, and it’s one that most investors don’t even know they have: currency hedging.
Believe it or not, buying something as broad as the iShares Core MSCI EAFE (IEFA) — with its 2,500 international stocks — can leave your portfolio to the whims of the cruel forex gods.
Wall Street has launched a whole bunch of new tools that can help average Joes fight the effects of currency on their portfolios return. The question is: Should you use them?
International ETFs & The All-Mighty Greenback
Despite the fact that foreign exchange is the world’s largest marketplace — trading trillions of dollars a day — many retail investors are blissfully unaware that their stock holdings actually are at the mercy of this marketplace.
But not knowing can be dangerous.
International stocks and bonds are making up larger percentages of modern portfolios thanks to a bevy of new options that offer exposure. That’s great news for investors looking to diversify — it’s just as easy to purchase shares of Malaysian equities (EWM) as it is shares of McDonald’s Corporation (MCD).
The problem is that many investors often do not realize that there is a two-part total return quotient to owning foreign assets. Part one is how the stock performs in its local currency, and part two is how that currency performs relative to the dollar. For example, an ETF such as iShares MSCI Canada Index (ETF) (EWC) owns stocks priced in Canadian dollars (loonies). However, when you place an order to buy the EWC, you are doing so in U.S. dollars.
That differential between the two currencies can mean a big difference in returns and sometimes can even turn a nice gain into a loss.
Using the Canadian ETF as an example, the MSCI index that the fund is based on increased approximately 12% over the last four years when priced in loonies. However, when pricing the index in U.S. dollars, the index actually lost 2.33% during that time period.
The culprit: An appreciating greenback versus the loonie.
This currency effect can also tinker with dividends paid by international stocks. As these dividends are paid in loonies, New Zealand’s kiwis or Thailand’s baht and translated back into dollars, the exchange rates can have an a dramatic effect. Investors can gain or lose. What might seem like a great yield at first blush might not be so great when it’s paid and your local currency has appreciated.
This effect can work both ways, boosting returns and dividends if your local currency is dropping. But our local currency isn’t dropping — the dollar continues to strengthen as the world’s investor’s look for a safe haven.
The U.S. dollar recently hit a seven-year high against the Japanese yen and reached a two-year high against the euro. And it doesn’t look like that trend will end anytime soon. The various QE programs currently being done across the world and relative strength of the U.S. economy should keep the dollar gravy train going for at least a few more years.
So what’s an investor to do? Take currency out of the equation.
Currency Hedged ETFs
There are now 35 currency-hedging ETFs with over $19 billion in assets in the U.S. today. The basic premise is that many of these ETFs use futures contracts and swaps to essentially take the currency out of the equation. Investors just get the stock returns and these ETFs provide “pure” exposure to whatever market they are trying to tap. If Japanese stocks are rallying, any drop or rise in the yen won’t matter.
For example, as the yen sank against the dollar, the uber-popular and unhedged iShares MSCI Japan ETF (EWJ) was roughly flat during last quarter. However, the hedged iShares Currency Hedged MSCI Japan ETF (HEWJ) was up about 12%. Investors in HEWJ didn’t have to worry about translating the yen-based stocks into dollars.
So the answer is to sell your international ETFs and buy only currency hedged versions, right?
Well, it’s not so simple. Remember, it wasn’t that long ago that the dollar was falling against all these other currencies and unhedged was the way to go.
The perhaps the easiest answer is to hedge your hedge. Certainly making a 60/40 non-hedged/hedged split with regards to a certain nation or region is warranted. Especially if you are looking to eliminate “hometown bias” and own a hefty slug of international stocks.
Both sleeves of your international portfolio with operate differently at different times. And that’s the real key for diversification and ultimately market-beating returns. Sometimes the dollar will rise, and sometimes the dollar will fall — as investors, you should be ready for both scenarios.
And since most investors stink at market timing, it pays to get a ahead of the curve.
As an investor who owns international stocks, you need to know how the forex markets can affect your returns and the ETFs you own. By using some of the new currency hedged ETFs, you can eliminate some of that headache.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.
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