Foreign Diversification Without the Currency Risk

Foreign stocks bear an additional layer of risk stemming from changes in foreign-exchange rates, making them more volatile than their U.S.-listed counterparts. But currency-hedged international-stock funds allow investors to benefit from global diversification without taking on extra risk. Currency-hedging won’t always help performance and could hurt tax efficiency, but it should consistently reduce volatility.

The fund tracks the MSCI EAFE 100% Hedged to USD Index, which covers stocks from the MSCI EAFE Index while hedging currency risk. This benchmark includes large- and mid-cap stocks from 21 developed markets outside of the United States. While it does not capture the full breadth of foreign markets, it does provide a well-diversified portfolio that covers a majority of the available market cap. Stocks from emerging markets and Canada are excluded. Collectively, stocks from these regions represent about 10% of a typical peer’s assets, so excluding them should not cause dramatic differences in long-term, Morningstar Category-relative performance.

Foreign stocks can be more volatile than a comparable portfolio of domestic stocks because they are exposed to changes in foreign-exchange rates. Over the long term, currency risk usually isn’t well compensated, which can make currency-hedging attractive for those who would prefer to avoid the extra volatility. This fund uses currency forwards to hedge its currency risk, which should reduce its volatility relative to the unhedged MSCI EAFE Index. However, it can cause the fund’s performance to deviate from its competitors’.

From its launch in January 2014 through December 2016, the fund outperformed 98% of its competitors because the dollar appreciated against many foreign currencies, benefiting a hedged strategy like this one. But the dollar subsequently depreciated in 2017, causing the fund’s total return to fall to the bottom of the category for that year. Over long periods, currency movements tend to have little impact on total returns.

BlackRock charges a 0.35% expense ratio for this fund, making it cheaper than the 0.88% category average. However, similar index-tracking funds that cover foreign developed markets are available for substantially less.

Fundamental View
Foreign stocks account for 47% of total global market cap. While this fund’s benchmark, the MSCI EAFE Index, is not the broadest representation of the foreign market, it does capture a majority of the available market cap listed outside of the U.S. and effectively diversifies stock, sector, country, and currency risks. This portfolio focuses on large-cap stocks, with major multinational firms like Nestle, Toyota, and BP among its top holdings. International corporations like these have global operations and diversified revenue streams, so they don’t provide clean access to the economies where they are headquartered. This makes their country of listing less important. But foreign stocks still serve an important role in an investor’s portfolio, as they can diversify a U.S.-centric portfolio.

Market-cap-weighted indexes like this one are cost-effective. Using this technique, a stock’s weighting will float with changes in its price and require very little turnover in order to maintain its desired exposures. This approach essentially free-rides on the judgment of active investors. The weighting of a given stock or sector will be an outcome of their collective opinions about each stock’s relative value. Low turnover translates into low transaction costs.

This approach can also be effective at diversifying stock-, sector-, and country-specific risks. Despite omitting emerging markets, this fund’s sector composition closely resembles the category average. The financials sector accounts for the largest slice of this portfolio and the category average, at roughly 20% of assets. Its wide reach also diversifies stock-specific risk better than many of its competitors, investing in more than 900 companies, with its 10 largest holdings accounting for only 11% of assets.

Market-cap weighting and the exclusion of small-cap stocks give the fund a larger market-cap orientation than most of its peers. Its average market cap is currently about one third larger than the category average. The fund’s exclusion of small-cap stocks slightly reduces its diversification potential.

This fund’s holdings include stocks from 21 different countries, exposing investors to a range of currencies, like the yen, pound, and euro. But the fund’s managers use forward contracts to hedge the additional volatility that foreign currencies create. Over the long-run, this should lead to a stream of returns that exhibits less volatility than the unhedged MSCI EAFE Index. So far, this has been the case. From its launch in January 2014 through February 2018, this was one of the least volatile funds in its category. Its volatility during this period was mildly higher than the S&P 500.

Portfolio Construction
The fund tracks the MSCI EAFE 100% Hedged to USD Index. It combines a diversified, low-turnover portfolio with a reasonable currency-hedging strategy, earning a Positive Process Pillar rating.

The fund’s selection process starts with stocks listed in 21 foreign developed markets and targets the largest 85% of this cohort by market cap. Buffer rules around the cutoff point are used to help reduce turnover. Qualifying stocks must also meet liquidity requirements to make the index easier to track and mitigate trading costs. Stocks that make the cut are weighted by market cap, which helps mitigate turnover and the related trading costs, since a stock’s weighting will float with changes in its price. The index is reconstituted semiannually in May and November. It makes smaller adjustments during additional quarterly reviews in February and August, such as adding recent IPOs.

The managers use

Fees
The fund carries a 0.35% expense ratio, making it cheaper than 85% of its peers in the foreign large-blend category. It earns a Positive Price Pillar rating, but 

Alternatives

IEFA is more compelling way to access stocks from the MSCI EAFE Index. It provides more-diversified coverage through its inclusion of small caps, holding more than 2,500 stocks with only 9% of assets in its 10 largest holdings. Its 0.08% expense ratio is competitive with the lowest fees in the foreign large-blend category, supporting a Silver rating.

Silver-rated

Investors who are looking to reduce volatility but prefer to avoid the potential capital gains that come with currency-hedging might consider

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