Int’l ETFs: Currency Hedged Vs. Low Vol

Looking to tame international equity risk with DBEF? Try EFAV instead.

Looking to tame international equity risk with DBEF? Try EFAV instead.

Investors have put big money into the db X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-55)—close to $300 million year-to-date. I hope they did so because they believe the dollar will strengthen relative to the pound, the yen, the euro and other developed-market currencies.

What’s less clear to me is that DBEF is a good choice for overall risk reduction in the international equity space, whether as a stand-alone play or in portfolio context. To get a sense of where DBEF falls on the risk-reward continuum, I stacked it up next to a purpose-built risk-reducing ETF—the iShares MSCI EAFE Minimum Volatility ETF (EFAV | B-52) and a plain-vanilla international equity ETF—the iShares MSCI EAFE ETF (EFA | A-91).

I framed the comparison carefully: All three funds are built around the same EAFE index, so there are no other exposure differences except for their strategies: currency-hedged for DBEF; minimum volatility for EFAV; and plain vanilla for EFA.

While the joint performance history is relatively short, the numbers clearly show that EFAV is less risky than DBEF by a variety of measures.

The table below shows volatility since EFAV’s inception. (It’s the newest fund, launched in October 2011.)

EFAV’s risk is lowest by this measure, but DBEF is also delivering a smoother ride than plain-vanilla EFA. I also ran downside risk numbers, which I won’t repeat here because they fall roughly in line with the volatility numbers.

Market risk or beta for the funds follows a similar pattern. I ran regressions for the same period of EFAV and DBEF on EFA, which revealed low-market risk of 0.76 for DBEF and an even lower beta of 0.62 for EFAV.

By these numbers, DBEF does a decent job, but EFAV is clearly a more muscular risk reducer.

What interests me is how the total return chart for the same period doesn’t look quite like what the numbers above suggest.

DBEF (the dark blue) almost looks like a higher-beta play on EFA, with seemingly more pronounced peaks and valleys. This led me to look at maximum drawdowns for the funds within this time range. While the volatility and beta numbers rely on daily returns, maximum drawdowns measure risk by looking at big drops over multiple days—the kind that show up on this chart.

From left to right, I focused on drawdowns in the second quarter of 2012, in June of 2013 and in January 2014. While EFAV has the smallest drawdowns in each case, DBEF has larger drawdowns than both EFAV and EFA in two of the three cases.

To me, the drawdown story matters because it comes closer to how investors “feel” risk for the time period. DBEF swooned hard in June 2013—you can see it on the return chart and in the drawdown table.

Still, with bigger downsides for DBEF have come bigger upsides in returns. DBEF leads all three funds since EFAV’s inception, and essentially matches EFA over the two-year period. These numbers, combined with DBEF’s lower one-year return, make me feel like its relatively low beta number doesn’t really indicate how twisty the road has been.

In Your Portfolio

DBEF and EFAV differ in stand-alone performance, as shown above, and their correlations with other core asset groups hint at how they work in a portfolio.

Without doubt, international equity is a core holding for many investors. I ran correlations of DBEF, EFAV and EFA against proxies for U.S. equity and a broad bond position to see what kind of diversifying power they bring. I used the Vanguard S&P 500 ETF (VOO | A-96) and the iShares Core Total U.S. Bond Market ETF (AGG | A-97), respectively.

To me, EFAV has the clear edge here again. It has lower correlation to U.S. equity—the dominant player in many portfolios—and it’s essentially uncorrelated with bonds.

DBEF’s extremes make sense. Without the counteracting currency component of returns, it behaves more like U.S. equities, showing higher correlation to U.S. equities than both EFAV and unhedged EFA, as well as more negative correlation with bonds. The latter might be attractive to those with especially large bond positions.

Still, for me the key takeaway is that DBEF’s currency hedge undercuts the diversifying power of international equity in a typical portfolio dominated by U.S. equities—a prime reason for being there in the first place.

Role Play

Let’s be clear: DBEF does its job well. It provides solid exposure to international equity—and hedged against currency moves for the U.S. investor. Its thesis is a strengthening dollar perhaps buttressed by a belief that developed-market equities will perform better as their currencies weaken (nudged by their central banks), and as the U.S. tapers its own currency debasement.

But if it’s safety you want while retaining some upside, EFAV is the better call, in my view.

Note too that either fund is well suited to be blended with EFA to fine-tune the exposure if the pure-play strategy is too strong for your taste.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.