(PUB) Investing 2015

volatility ACWI index had an MCL of -38.6% versus the traditional index’s -54.6% MCL—that is a meaningful difference. Most investors aren’t going to be able tell the difference between the hedged EAFE index’s -51.2% MCL and the unhedged EAFE index’s -56.7% decline. In this case, the cost of hedging arguably outweighs the benefits. By the way, this isn’t the only fund where Vanguard uses currency hedging techniques; Total International Bond also features the strategy. The argument for hedging is stronger for the bond fund, where historically the slight drag on returns has been matched with sig- nificantly reduced risks—both in terms of volatility and drawdown. (For a deeper review of currency hedging and the Total International Bond fund, see the story “Seeking Income Overseas” in the June 2013 newsletter.) This question of how much cur- rency risk to expose investors to is front and center as Vanguard continues to increase the allocation to foreign stocks and bonds in the Target Retirement and STAR LifeStrategy funds-of-funds. As a reminder, Vanguard is increasing the foreign stock allocation in these portfolios to 40% of the overall stock allocation—not far from the near 50/50 split of Total World Stock Index. Total International Bond will be 30% of the bond allocation, but the currency risk there is hedged, unlike in the stock por- tion. In explaining the increases to its foreign exposure, Vanguard pointed to moving closer to the worldwide market cap and reducing country-specific risk. Additionally, Vanguard said that the increase is facilitated by falling costs of investing overseas. What is missing from the discussion is the increased currency risk the changes bring. Vanguard has consistently said that investors should hedge currency risk related to owning foreign bonds. I can swallow that, but by Vanguard’s own admission in a September 2014 research report, To hedge or not to hedge? Evaluating currency exposure in global equity portfolios , “the case for hedging [currency in] an equity

stituent stocks hedged back to the U.S. dollar, since 1969. When the line is rising, the traditional EAFE index is outperforming its hedged sibling. Over this nearly 45-year period, the EAFE index compounded at a 9.1% annual rate, while the hedged EAFE index gained at a 7.8% rate. This 1.3% annual difference really adds up over time, as the EAFE index’s cumula- tive return of 5,082% far outpaces the 2,870% total return for the hedged index. As with the minimum volatil- ity index’s strategy, hedging also had periods of outperformance. As the dol- lar strengthened in the early 1980s and again in the late 1990s through the early 2000s, the hedged index outperformed the traditional EAFE index. The ques- tion is just how far along into one of those cycles we are right now. As I said, risk was only marginally lower for the hedged index. Comparing maximum cumulative losses (MCLs), my preferred measure of risk, the hedged index’s worst decline was a drop of -51.2%, while the EAFE index’s largest drawdown was -56.7%. Looking at volatility, the 14.4 standard deviation of the hedged index was a touch below the 17.1 standard deviation of the EAFE index. In choosing to hedge the curren- cy risk, Vanguard is emphasizing risk control, rather than going for the best return, and so far that’s paid off. But when you come right down to it, a low- volatility portfolio construction process has a much more meaningful impact on reducing risk than hedging curren- cies does. Remember, the minimum

had a standard deviation of 10.6, com- pared to a standard deviation of 15.3 for the traditional version. In sum, the minimum volatility index won by losing less when markets were falling, and, true to its name, did so with meaningfully less volatility, with monthly returns ranging closer to its average than the traditional index. While MSCI and Vanguard probably have somewhat different approaches to constructing minimum volatility port- folios, the data do suggest that a mini- mum volatility portfolio may deliver stock-like returns with less risk over the long run, particularly if that period includes one or more substantial bear markets. Not only has the minimum volatility strategy outperformed in the two bear markets for which we have data, but it has kept a reasonable pace with the traditional index in two of the three bull markets over the last 20 years. However, I would emphasize that the minimum volatility index did not outperform each and every year. In fact, there were stretches, particularly dur- ing the bull market of the mid-to-late 1990s, when the minimum volatility index meaningfully lagged the tradi- tional index. Hedging Understanding and assessing the currency hedging component of Global Minimum Volatility is a bit more com- plex. It certainly paid to hedge the dol- lar against foreign currencies in 2014 as the dollar strengthened big-time. For instance, the dollar gained 13.6% against the euro in 2014 and has contin- ued to gain on it this year. If you expect the dollar to continue to strengthen, then you would want to keep hedging your currency risk. But the bigger ques- tion is what to do about the long run. (See the box on page 15 for the basics of currency hedging.) The short story is that hedging cur- rencies on a foreign stock portfolio has reduced returns while slightly dampen- ing risk. The chart to the right shows the relative returns of the MSCI EAFE index (a broad index of foreign devel- oped stocks) versus the same index with the foreign currencies of its con-

The Cost of Hedging Currency Risk

2.25 Rising line = Unhedged EAFE outperforming Hedged EAFE

2.00

1.75

1.50

1.25

1.00

0.75

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2/70

2/75

2/80

2/85

2/90

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2/00

2/05

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The Independent Adviser for Vanguard Investors • April 2015 • 7

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