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.

 

 

Total Return Performance of DBEF vs EFA

 

When compared against DBEF since its June 2011 inception, there’s no doubt that the pound, yen and euro have taken their toll on EFA—the fund gained only 4.5 percent, while DBEF climbed 14.91 percent in the same period.

Even if you don't have an opinion on currency movements, the prudent strategy is to maintain a 50/50 exposure to EFA and DBEF. That way, you can maintain neutral exposure to the underlying currencies' effects.

So why have most investors “slept on” DBEF? Quite simply, it’s because of liquidity.

DBEF only trades an average of 10,000 shares per day, and bid/ask spreads have been fairly sporadic, reaching as much as 0.69 percent, or nearly double the fund’s expense ratio of 0.35 percent.

That may not be an issue for large orders, of course. But investors buying smaller blocks would be best served by reaching out directly to the ETF issuer’s capital markets desk; in this case, Deutsche Bank.

The capital markets desk would be more than willing to help facilitate your trade in order to ensure you can get in and out of the fund at fair prices by using Deutsche Bank’s own network of liquidity providers.

What I’m saying is this: No matter how you approach it, it pays to keep on top of currency exposure in your portfolio, and ruling out currency hedge strategies based on liquidity could cost you.


At the time this article was written, the author had no positions in the securities mentioned. Contact Ugo Egbunike at [email protected].


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