Time To Hedge EAFE Exposure

March 18, 2013

Given the race to debase among central banks, investors should know about tools to help them take cover.

 

Currency-hedged Japan ETFs have been in the spotlight lately, but there are other plays available outside of the Land of the Rising Sun.

The iShares MSCI EAFE ETF (NYSEArca: EFA) has long been the go-to play for exposure to the developed ex-U.S. market.

Unfortunately, most investors forget about the inherent currency exposure involved in owning EFA and other international funds. But in June 2011, Deutsche Bank launched the perfect complement to EFA—the db X-trackers MSCI EAFE Hedged Equity Fund (NYSEArca: DBEF)—and it’s starting to show its true colors.

First, let's review how currency exposure works.

Because EFA holds international stocks, its fund managers must exchange U.S. dollars for foreign currency before buying the ETF's portfolio. When the net asset value of EFA is calculated at the end of the day, however, the fund's custodian must convert the value of those stocks back into dollars.

That means there's an additional variable at play in the ETF's value: If the foreign currency appreciates against the dollar, investors will see a greater return than just the pure equity performance. Conversely, when the foreign currency depreciates relative to the dollar, the return erodes.

While DBEF provides the exact same exposure as EFA—it tracks the same index, after all—it also hedges out the foreign currency exposure.

 

Currency Returns Since 2011

 

That matters, because EFA is in the crossfire of what increasingly seems to be a currency war between central banks.

By nature of its exposure to European and Japanese stocks, 90 percent of the fund is exposed to the British pound, the Japanese yen and the euro—all currencies that have seen negative returns since DBEF’s launch in 2011.

From a performance level, when comparing EFA and DBEF, the currency-hedged strategy certainly speaks for itself.

 

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