A large part of the outperformance in U.S. equities, or underperformance in international stocks, may be attributed to the stronger U.S. dollar. Consequently, investors may find that a currency-hedged equity exchange traded fund is a better pure play on international equities.
Foreign equities have lagged U.S. markets in dollar terms for some time. For instance, the S&P 500 generated an annualized 22.5% through January, compared to the 14.9% for the MSCI All-Country World ex USA Index, writes Morningstar analyst Kevin McDevitt.
While some market observers have pointed to the underperformance as a valuation opportunity, McDevitt warns that the valuation gap may not be as defined as most would believe.
“That valuation gap doesn’t exist to the usual extent in this case because so much of the recent U.S. equity outperformance has owed to the soaring dollar,” McDevitt said. “During the 12 months through Feb. 11, 2015, the U.S. dollar has gained 17.3% versus the euro, 15% versus the yen, and 7.4% versus the pound.”
However, in local currency terms, the foreign equities have fared much better. For instance, while the MSCI ACWI ex USA Index dipped 0.7% in dollar terms over the past 12 months through February 11, it gained 12.3% in local currency terms.
ETF investors, on the other hand, can also track a more pure-play foreign equity position through a currency-hedged equity ETF. For instance, the Deutsche X-trackers MSCI All World ex US Hedged Equity ETF (NYSEArca: DBAW), which hedges against depreciating foreign currencies, has increased 13.8% over the past year, whereas the iShares MSCI ACWI ex U.S. ETF (NasdaqGM: ACWX), which does not hedge its currency exposure, rose 1.1%.
Unlike other non-hedged international ETFs, DBAW’s underlying index is designed to diminish exposure to fluctuations between the value of the U.S. dollar and those of non-U.S. countries. However, potential investors should be aware that a currency-hedged ETF may underperform a non-hedged ETF if the local currencies begin appreciating, or the U.S. dollar weakens.