Boosting Poor Foreign Stock and U.S. Bond Fund Performance

By Tom Madell

Summary: This article may not appeal to all readers, especially those who do not choose to invest in international stock and/or bond funds/ETFs. However, the data presented below is hard to dismiss. And, if you only hold domestic bond funds, you should also consider what the data shows. If you find reading the discussion a little beyond your level of interest, you may want to consider just this one suggestion from it: "Ordinary" international stock and bond, as well as domestic bond funds/ETFs may show weaker returns as compared to a few "specialized" international stock and bond funds. The performance differences between these types of funds may be stark, as I show have occurred over the last 10 years. Therefore, you should consider owning one or more of the funds shown in dark, bold type below.

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If you have money invested in most foreign stock funds/ETFs, you likely are aware that over the last 10 years or so, such funds have significantly underperformed most domestic (US) funds. Here is an example of the degree of this underperformance comparing two Vanguard index funds, the first consisting of domestic stocks and the second foreign stocks, through year end 2018 and YTD.

Note: All 5 and 10 year performance mentioned in this article is annualized thru year end 2018; year-to-date return (YTD) is thru 8-2-19

Given struggling economies in many non-US countries as opposed to the better shape of the US economy, such underperformance may not change any time soon. However, it still makes sense to keep at least some of your investments invested abroad for diversification purposes. So if you do continue to invest abroad, you will likely want to have a chance to maximize your foreign returns especially if this very long underperforming trend continues.

One way to potentially do this is to consider keeping some of your international investments in a type of investment that attempts to boost foreign returns if a certain condition applies. So what is this condition and does it seem to apply looking forward?

If you were to take a trip abroad, such as I did recently to Canada, you might notice that your US money seemed to be buying more than you might have expected. A hotel in Canada, which might be priced at $100 a night in Canadian dollars might show up on your credit card statement as only costing about $75 in US dollars.

This hasn't always been the case. In fact, had you been in Canada in 2011, a similar $100 charge in Canada might actually have cost you even a little more than $100 when it was converted to US dollars on your statement. This reflects the fact that exchange rates between two countries tend to go up and down over the years. And for the Canadian to US exchange rate, the US dollar has tended to get stronger vs. the Canadian dollar during much of the 2011 to 2019 period. The same has been true of many other foreign currencies vs. the US dollar over the last 10 years or so. So if you had taken a trip to any country using the European currency, the euro, such as France or Germany 10 years ago, your US dollar would be worth more now than it was back in 2009. This phenomenon is known as dollar appreciation, or a rising dollar, although currency stability, or even dollar depreciation (a falling dollar) is certainly possible.

When it comes to your international investments, at the time you purchase shares, each share of the fund is priced in US dollars. But suppose the US dollar has generally risen since you bought those shares. This would consequently mean that the currencies, although not necessarily the prices, that denominate the international shares in the portfolio have generally been falling. If you sell these shares, the fund must first liquidate your shares in the foreign countries' currencies. Whatever the current fund price, since the foreign currencies have fallen vs. the US dollar from the time of your purchase, you will lose some of the value of your investment regardless of whether the international stocks themselves have gone up or down.

Hypothetically, for example, if you bought a European region fund when the euro exchange rate was 1.00 to the dollar, meaning every euro bought 1 dollar, and now it has subsequently dropped to 0.90, meaning the euro would now worth somewhat less than a dollar, one share when converted back to dollars will have lost 10% in the exchange. Even if the stocks in the funds have actually gone up 15% since your purchase, you will only receive a 5% gain from the redemption (i.e. 15% minus 10%).

Since, as stated above, the dollar has been appreciating substantially over the last 10 years (approximately 24% using a commonly used measure of dollar strength), this means that a international stock fund share would have depreciated by about that much regardless of how well the portfolio of stocks themselves performed. Thus, given this obstacle among others, it should be no surprise that foreign funds have trailed US funds badly.

However, a select few mutual funds and ETFs employ a technique called currency hedging to try to offset such losses if the US dollar is appreciating against a basket of foreign currencies. (This is not to be equated with the usually much riskier practices of so-called "hedge funds.") Suffice it to say that such US dollar hedging mutual funds/ETFs try to eliminate the risk of loss associated with a rising dollar. So if the currency hedge was working successfully after you purchased your fund and subsequently the dollar rose by 10%, you would not experience the 10% currency loss described in the example above.

Since the US dollar has been appreciating against the currencies of many foreign countries for the better part of 10 years, funds that have used currency hedging over that period have tended to do better than most funds that do not. Here are some stark examples:

Note: NA in any table means the fund hasn't existed for 10 years.

So far, I have only mentioned foreign stock funds that can protect against a rising dollar. But when investing in international bond funds/ETFs, you may also get a boost with currency hedged funds when the dollar is rising.

Let's look at how two hedged international bond funds, both of which I have recommended at various times on my website (for example, see the July 2014 Newsletter), did as compared to the most popular Vanguard domestic bond index fund:

Even if you hold an international bond fund, if it hasn't been a hedged fund, it may be severely underperforming.

Consider the returns of two nearly identical bond funds in terms of their holdings, except the first shown below is hedged while the second isn't:

Note: Both of the above two funds have a 3.75% load which is not reflected the performance figures shown; I do not recommend investors purchase funds with a load. The two funds are shown only for illustrative purposes.

So it appears then that as long as the US dollar continues to appreciate, currency hedged international stock or bond funds or ETFs may continue to have an advantage over their non-hedged brethren. Of course, if the dollar reverses and goes into a period of overall depreciation, a hedged fund will be at a disadvantage. This is what appeared to have happened in 2017 which was an exception to the rising dollar every other year between 2014 and 2019. The results for the above hedged vs. unhedged funds for 2017 are shown below confirming that in that year, unlike the average annual returns shown above, the weaker dollar favored the unhedged funds.

Tweedy, Browne Global Value (TBGVX) 15.4
iShares MSCI EAFE ETF (EFA) 25.1

WisdomTree Europe Hedged Equity ETF (HEDJ) 13.5
Vanguard European Stock Index Admiral (VEUSX) 27.1

PIMCO International Bond (USD-Hedged) A (PFOAX) 3.1
PIMCO International Bond (Unhedged) A (PFOAX) 10.4

PIMCO International Bond (USD-Hedged) Adm (PFRAX) 3.3
Vanguard Total Intl Bd Idx Admiral (VTABX) 2.4
Vanguard Total Bond Market Index Adm (VBTLX) 3.6

How can one be confident that the US dollar will continue to rise against a basket of foreign currencies, aside from the strength of the 10 year plus rising trend cited above? Here are several reasons why the dollar is likely to continue to rise:

-Since the US economy is stronger than most foreign economies right now, this strength attracts foreign investors, as well as those in the US, to US investments which are thought to have a better chance of doing well. More money flowing into US and out of foreign investments favors the US dollar.

-US interest rates are considerably higher than most rates abroad; this too favors investing in US bonds as opposed to foreign bonds, pulling money into the US as opposed to bonds abroad.

-Central banks abroad are tending to lower interest rates abroad and use quantitative easing as a way to stimulate their economies; the US is perhaps unlikely to push interest rates much lower and has stopped using quantitative easing.

-Although the US might try to devalue the US dollar, the Trump administration has recently rejected using this as a way to lower the dollar.

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