On the recent webcast (available On Demand for CE Credit), Tired of Trying to Determine Which Way the Dollar is Headed?, Salvatore Bruno, Chief Investment Officer and Managing Director of IndexIQ, pointed to the growth opportunity in global markets. For instance, many global developed economies are expected to expand 2% to 4% in 2018. Emerging markets, notably “China, India and Southeast Asia are the growth envy,” as they are projected to grow over 4%. The Eurozone is also enjoying a pick up as growth, business and earnings indicators are positive and gaining momentum.
Meanwhile, valuations also look much more attractive outside the U.S., especially after the recent rally in domestic equities that has pushed U.S. stocks to record highs and forward price-to-earnings ratios to historically elevated levels. For example, the MSCI Europe Index shows a 15.1 P/E ratio, MSCI Japan trades at a 14.6 P/E and the FTSE World Ex U.S. hovers around 14.5 P/E, compared to the 18.1 P/E in the S&P 500. International markets are also relatively cheap compared to historical averages.
“Relative valuations for international developed equity markets are almost one full standard deviation below their 30-year average,” Bruno said.
Income-minded investors are also looking in international markets as yield opportunities look more enticing. The S&P 500 shows a dividend yield of 2.0%, compared to the MSCI World’s 2.4%, MSCI EM’s 2.4% and SMCI EAFE 3.1%.
However, as more investors look to international markets to diversify their portfolios, people will have to consider specific risks associated with foreign equity exposure, such as foreign exchange fluctuations or currency risks.
“Investors must consider what to do about the inherent currency risk that comes with international investing. Options can range from hedging 0% to 100% of the exposure,” Bruno said.
Yan Yan, Associate Director of Research and Analytics at FTSE Russell, pointed out that investors may be overlooking the potentially damaging negative effects currency risks on international equity exposure over the short-term. For example, from June 2014 to June 2015 when the U.S. dollar strengthened or foreign currencies depreciated against the greenback, a 0% unhedged position in the FTSE Developed ex North America Index generated a -2.5% return, whereas a fully 100% hedged position in the index would have generated a 10.8% return over the period.
“Currency is not viewed as an economic asset and theoretically should have no long-term expected return,” Yan said. “However, in the short or medium-term, currency can have significant return impact.”
Yan argued that currency risk is a major contributor to volatility in foreign equity exposure. From the period ended 2004 through September 2017, the annualized volatility for a 0% unhedged FTSE developed ex North America Index was 17.20%, compared to a volatility of 13.83% for a 100% hedged index. This shows that investors who want long-term exposure to foreign equities may diminish portfolio volatility by simply hedging their currency risk.
However, there are periods in between when the dollar weakness and an unhedged position may benefit from stronger foreign currency exposure.
“Uncertainty in return or risk reduction, together with time varying correlations makes hedging a challenging decision,” Yan said.
Investors who are interested in foreign equity exposure may then consider a 50% hedged and 50% unhedged international portfolio to take on a more neutral market position that captures foreign equity returns while somewhat diminishing portfolio volatility associated with currency risks to produce improved risk-adjusted returns over time. A 50% hedge embodies no currency forecast in a neutral position, minimizes investor regret, cuts down hedging costs and historically exhibited non-linearity in volatility reduction, Yan said.
ETF investors interested in foreign market exposure and in taking a more neutral view on foreign currency movements can consider a handful of 50% hedged/50% unhedged options, including the IQ 50 Percent Hedged FTSE International ETF (NYSEArca: HFXI), IQ 50 Percent Hedged FTSE Europe ETF (NYSEArca: HFXE) and IQ 50 Percent Hedged FTSE Japan ETF (NYS Arca: HFXJ). All three funds have approximately half their currency exposure of the securities in the underlying index hedged against the U.S. dollar on a monthly basis.
Financial advisors who are interested in learning more about currency-hedged international strategies can watch the webcast here on demand.