- Investors are turning to broad EAFE – developed Europe, Australasia and Far East – Index ETFs
- Popular picks include EFA, VEA and DBEF as they utilize currency forward contracts to diminish negative effects of weaker foreign currencies
- Investors with currency-hedged developed EAFE market exposure are receiving a positive cost of carry from each of the four biggest currencies in the international basket
Currency-hedged exchange traded funds have become a popular way to access international markets while hedging currency risks. While some may be concerned about the costs of implementing these currency hedges, the benefits have outweighed the costs.
For developed international market exposure, investors have turned to broad EAFE – developed Europe, Australasia and Far East – Index ETFs, like the iShares MSCI EAFE ETF (NYSEArca: EFA) and Vanguard FTSE Developed Markets ETF (NYSEArca: VEA).
However, when accessing overseas markets, investors will be exposed to currency risks – a strengthening U.S. dollar or weakening foreign currency diminishes international equity returns. Alternatively, investors may look at a number of currency-hedged international ETF options to capture foreign exposure while hedging currency risks, such as the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF), which utilize currency forward contracts to diminish the negative effects of weaker foreign currencies.
Some may be concerned about the costs to implement the hedging strategy, especially as fund managers sell a foreign currency forward at a different rate to where the spot rate is. Investors typically bear a hedging cost when the interest rate is higher on a foreign currency than it is on the U.S. dollar, Deutsche Asset Management strategists Abby Woodman, Dodd Kittsley and Robert Bush said in a research note.
On the other hand the opposite is also true. When U.S. rates are higher than foreign ones, hedging becomes a net benefit for U.S. investors as there is a “positive cost of carry.”
“For many currencies today, including the euro, pound, yen and Swiss franc, one-month interest rates are lower than they are for the U.S. dollar, resulting in a hedging ‘benefit’ to U.S.-based investors removing their international foreign exchange (FX) exposures,” Deutsche strategists said.
Looking at DBEF’s underlying MSCI EAFE currencies, we see that five of the 12 developed market currencies show negative one-month deposit rates, including a -0.17% rate for the euro, which makes up 30.4% of the EAFE index, a -0.21% rate on the Japanese yen, which is 24.2% of the index, and -0.74% rate on the Swiss franc, which is 9.3% of the benchmark.
More importantly, most foreign currency rates to the USD show a positive spread – the U.S. dollar rate is higher than the foreign rates, which provides a positive cost to carry, or a benefit, for hedged investors. Specifically, among the top four currency exposures, which make up 83% of the EAFE Index’s weighting, the EUR shows a +0.70% spread to USD, JPY shows a +0.74% spread to the USD, the GBP has a +0.03% spread to the USD and the CHF has a +1.27% spread to the USD.
“Anytime the U.S. dollar rate is higher than the foreign rate (the ‘Spread to USD’ row is positive) then there will be a positive cost of carry,” the Deutsche strategists added. “Or, to put it another way, the investor gets paid to hedge.”
Currently, investors with currency-hedged developed EAFE market exposure are receiving a positive cost of carry from each of the four biggest currencies in the international basket.
Deutsche X-trackers MSCI EAFE Hedged Equity ETF