February 9, 2012
Vanguard's Forex-Hedged Foreign Bond ETFs
Vanguard will soon be launching its first foreign-bond funds, although the roll-out date has been delayed, the firm reports. The proposed set of ETFs and index mutual funds will target a broad definition of foreign bonds as well as products for emerging markets. But unlike most of the existing foreign bond ETFs, such as SPDR Barclays International Treasury ETF (BWX) and Van Eck Market Vectors Emerging Market Local Currency Bond ETF (EMLC), the new Vanguard funds will hedge currency exposure from a U.S.-dollar-investor perspective. Vanguard argues that this is a superior approach for U.S. investors investing in foreign bonds because it will dampen volatility. True, but it's not clear that this is a better way to manage a foreign bond fund.
The general case for holding foreign bonds as part of a broad asset allocation strategy is widely accepted. Indeed, unless you’re intentionally making a strong tactical bet, sidestepping such a large slice of the world’s capital markets is misguided as a strategy matter. The literature on this point is well established. The main question is deciding if you should hedge the currency exposure or not?
A relevant point in this debate is recognizing that the currency factor tends to be a wash in the long run. In the short run, of course, forex is quite volatile. But unless you plan on making lots of short-term tactical trades based on currency volatility, it's not clear that this is a crucial issue. For example, consider that the Trade-Weighted US Dollar Index for the world’s major currencies posted an average one-year change of -0.9% for the past 30 years, or relatively close to zero. In other words, the fluctuations bounce around a zero mean. That’s another way of saying that there’s relatively no trending behavior. For comparison, the U.S. stock market (S&P 500) has a clear history of trending, as suggested by its average one-year change of 9.4% for 1981-2011.
Of course, if volatility is a short-term concern, hedging has appeal. Vanguard advises that “unhedged bonds add a level of volatility more similar to equities than to bonds and can therefore offset any diversification benefit of international bonds.” That’s true, but as part of a broad asset allocation strategy using the major asset classes it’s not obvious that the extra volatility is detrimental. Depending on the time period, the extra vol may even be productive. In fact, as I recently reported, a passive mix of the major asset classes (including unhedged foreign equity and bond positions) has proven to be competitive with actively managed asset allocation funds over the past decade.
Consider too that a U.S. investor is well advised to diversify her currency exposure beyond greenbacks. In a globalized economy, betting the house on one currency--even if it's the world's reserve currency--looks extreme. Unless you have some definite views on the dollar, particularly in the short and medium terms, there’s a compelling case for holding at least some of your assets in non-dollar-denominated assets. It's tempting to forecast that the dollar will strengthen, or weaken, over some future time horizon, but accuracy is notoriously scarce in forex predictions, even by the standards of equity investing.
Keep in mind too that currency hedging is expensive as a long-term proposition. That said, Vanguard’s new foreign bond ETFs will carry relatively low expense ratios of 0.30% for the broad fund, and 0.35% for the emerging markets product. Those levels are at the bottom end relative to the existing product lineup. But if Vanguard didn’t plan on hedging currency risk, it’s reasonable to assume that the expense ratios would be even lower.
In the long run, currency hedging almost certainly comes at a price. This point is quite clear in the newly published Credit Suisse Global Investment Returns Yearbook 2012. Hedging can help soften return volatility in the short run, the study notes, but over longer-term horizons the strategy takes a bite. “Typically, the benefits fall the longer the horizon, and rapidly turn negative,” according to the yearbook’s authors (including Elroy Dimson of the London Business School). “Rather than lowering risk, hedging by longer term investors raises risk.”
The currency factor is, of course, a source of risk. In isolation, this risk can be dangerous, particularly for the average investor. Indeed, as the Credit Suisse study reminds, predicting currency returns is quite difficult, perhaps even more so than for stocks and bonds. But holding a portfolio of different and relatively uncorrelated risks can be beneficial, especially if you have a long-term investment horizon.
Then again, generic prescriptions only go so far. Much depends on your specific asset allocation. Keep in mind that if you own foreign stock funds, you probably already have a fair amount of forex exposure--most non-U.S. equity funds don’t hedge, or do so minimally.
Meantime, let’s no dismiss Vanguard’s argument for hedging completely. Forex volatility may be a wash in the long run, but in the short term it can radically help or hurt returns. Since bond returns are generally modest compared with stocks, an unhedged foreign bond allocation can be quite volatile. But volatility for a given asset class isn’t necessarily troublesome if it’s part of a broadly diversified mix.
Nonetheless, the larger question is whether you want exposure to a currency other than the U.S. dollar? For most investors, there’s a good argument for answering “yes,” albeit in moderation. But if you disagree, or prefer to access forex risk through something other than the fixed-income channel, Vanguard will soon offer a competitive alternative. For sophisticated investors, the prospect of using the Vanguard product and making a separate allocation to forex with, say, one or more currency ETFs is another possibility.
Any way you slice it, forex is a big deal when venturing into foreign markets. Indeed, the forex factor is likely to be the overwhelming driver of returns for foreign bond allocations, for good or ill, in the short and medium terms. The problem is that it's quite difficult to figure out in advance if this influence will help or hurt. That inspires opting for the unhedged allocations and looking for risk management tools elsewhere, starting with broad diversification across asset classes. There are many ways to manage risk, but some are more compelling (and less costly) than others.
Update: A bit of long-run forex perspective from a new research report from Andrew Smithers, who writes: "France and the US have grown at almost exactly the same pace over the past 110 years and their real exchange rates today are also almost exactly the same as they were at the end of 1900."
Posted by jp at February 9, 2012 5:12 AM