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Can Currency Hedging Protect Your International Stock ETFs?

Time to Consider Currency-Hedged ETFs?

The U.S. dollar’s 20% rise in relative value over the past year or so is proving to be a mighty strong headwind for international stock exchange-traded funds (ETFs) that are fully exposed to currency fluctuations.

No wonder investors have an increased appetite for investments that try to mitigate, or hedge, the impact of currency swings. According to Morningstar, assets in international stock ETFs that hedge their currency exposure have almost tripled in 2015, amounting to approximately $60 billion.

Tempted to jump on the currency-hedging bandwagon? Don’t act too quickly. Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory, cautions that employing currency hedging in your stock portfolio could in fact trip you up.

Why currency hedging looks attractive right now

While the U.S. economy is making gains, much of the rest of the world is struggling. As a result, many foreign currencies are weak compared with the U.S. dollar and thus convert into fewer dollars. So a portfolio that contains, say, German software behemoth SAP, which is priced in euros, or Honda Motors, which is priced in Japanese yen, is getting hit as the dollar flexes its muscle.

Hedging exchange-rate risk—buying financial instruments that counteract the effects of currency fluctuations—can soften the impact of currency swings.

Take the MSCI EAFE 100% Hedged to USD Index, for example. It tracks the same index of stocks from developed nations across Europe, Australasia and the Far East as the MSCI EAFE Index does. But while the hedged index gained 5.5% over the past 12 months, the index with no currency protection lost 7.5%.

So hedging might seem like a no-brainer. But Michael warns that while hedged international stock portfolios have worked as a tactical move in the short term, hedging may undermine your long-term strategy.

“You have to ask yourself why you are invested in international stocks in the first place,” he says. “Most likely, it’s for diversification, and currency diversification is part of the larger diversification argument. If you hedge your international stock portfolio, you are giving up an important layer of diversification.”

The long-term case against currency hedging

Indeed, if you’re focused on the long term, the smart move is to tune out the dollar’s surge and stick with your unhedged stock funds or ETFs.

While the dollar is having its day right now, Michelle Gibley, director of international research at the Schwab Center for Financial Research, notes that currency fluctuations tend to even out over time. And in hindsight, the time to hedge was in May 2014, when the dollar was 20% cheaper than it is today. Jumping in now presumes that you believe the dollar is going to keep rising in value from an already strong position.

History actually suggests that longer-term investors can tilt their odds toward better performance if they don’t hedge their international stock portfolio. As shown in the chart here, the unhedged MSCI EAFE Index beat the performance of the hedged portfolio in the majority of long-term rolling periods, dating back to 1969.

Chart 1: An unhedged portfolio might be better long-term

Exceptions worth noting

While patient long-term investors have reason to stick with an unhedged international stock portfolio, bonds are a whole other matter. If you own high-grade foreign bonds as part of your fixed income portfolio, the bulk of your returns tend to come from interest payouts, which are in the low single digits in most countries. This raises the risk that currency swings could wipe out your interest payment—and possibly the value of the bond. That’s why investors with foreign bond exposure might consider a hedged ETF.

Also, for some investors, a hedged approach to international stocks can make sense on a personal level. If you’ve learned enough about yourself to know that less volatility helps you stick to your long-term plan, adding a currency-hedged component to your stock portfolio can help smooth out the ride.

According to Morningstar, over the past 15 years the hedged version of the MSCI EAFE Index was 20% less volatile than the unhedged index. (Just remember that you may be signing up for lower returns over the long term than if you stick with an unhedged portfolio.)

Finally, Michael notes, retirees who are relying on investment income may want to consider hedging their international stocks. If you’re counting on international stocks to generate some of your income, you probably won’t be thrilled when a strong dollar cuts into your returns. By owning a hedged international stock ETF, you can help take currency swings out of the equation.

What you can do next

  • If you’re investing for the short term and are worried about currency fluctuations, consider hedging your international stock exposure.
  • If you’re more concerned with long-term goals, it’s probably best not to hedge your international stock exposure.
  • Find a Schwab Financial Consultant in your area who can walk you through the pros and cons of hedging your international holdings.
  • Use the Schwab ETF Screener to find ETFs that might fit your investing goals.
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Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

All security names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Charles Schwab Investment Advisory, Inc., is an affiliate of Charles Schwab & Co., Inc.

MSCI EAFE Index is made up of country indexes including large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.

MSCI EAFE 100% Hedged to USD Index represents a close estimation of the performance that can be achieved by hedging the currency exposures of its parent index, the MSCI EAFE Index, to the USD, the “home” currency for the hedged index. The index is 100% hedged to the USD by selling each foreign currency forward at the one-month Forward weight.

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