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To Hedge Or Not To Hedge?

This is an updated version of an ETF Specialist originally published on Feb. 19, 2014. Currency-hedged exchange-traded funds have come into vogue of late in the United States. Investor interest was first piqued by the performance of the oldest and largest of them all: WisdomTree Japan Hedged Equity (NYSEARCA: DXJ ) . The fund owns a portfolio of dividend-paying Japanese stocks that generate more than 80% of their revenue outside of Japan. It gained nearly 42% in 2013, as a massive dose of monetary stimulus contributed to an 18% decline in the value of the Japanese yen, and steady improvement in the global economy gave Japan’s stock market an additional boost. In contrast, iShares MSCI Japan ETF (NYSEARCA: EWJ ) , which tracks a standard market-cap-weighted benchmark and does not hedge its yen exposure, increased by 26% in 2013. Clearly, it paid for U.S. investors in Japanese stocks to have a hedge against a declining yen over this span. But was this a flash in the pan, or do currency hedges have value over longer time frames? With the U.S. dollar marching steadily higher–thanks in part to (relatively) attractive interest rates–and double-digit moves in major currencies making headlines, now is a good time for investors to explore these questions. Back to Basics: Return, Risk, and the Practicalities of Putting a Currency Hedge in Place In simple terms, a domestic investor’s local-currency-denominated return in a foreign security (or a portfolio of them) is equal to the foreign security’s (or portfolio’s) return plus the foreign currency return, plus the product of the foreign security return and the foreign currency return. The last part of this equation accounts for the interplay between the two, and as it is the product of these two figures, its contribution to the overall return will grow as either the foreign asset return or the foreign security return grows larger. Domestic Currency Return = Foreign Security Return + Foreign Currency Return + (Foreign Security Return x Foreign Currency Return) The effect of fluctuating exchange rates can either help or hurt returns. In the case of U.S. investors holding Japanese stocks, the yen’s depreciation hurt the U.S. dollar return for unhedged investors in 2013, as evidenced in part by the iShares fund’s relative underperformance versus the WisdomTree offering. In another extreme example, the 34% appreciation of the Brazilian real contributed to the 124% calendar-year return posted by iShares MSCI Brazil Capped ETF (NYSEARCA: EWZ ) in 2009. These examples highlight that currency effects can be extreme in magnitude. It’s also important to consider currencies’ effect on the risk of a portfolio of foreign securities: The expression for the variance (the square root of which is the standard deviation) of a foreign security or portfolio’s returns is as follows: σ 2 $ = σ 2 LC + σ 2 S + 2σ LC σ S ρ LC,S, where σ 2 $ = the variance of the foreign asset returns in U.S. dollar terms; σ 2 LC = the variance of the foreign asset in local-currency terms; σ LC = the standard deviation of the foreign asset in local-currency terms; 2 S = the variance of the foreign currency; σ s = the standard deviation of the foreign currency; ρ LC,S = the correlation between the returns of the foreign asset in local-currency terms and movements in the foreign currency. This expression demonstrates that the volatility of a foreign asset in domestic-currency terms is directly related to the volatility of the asset in local-currency terms (the first term in the expression) and the volatility of the foreign currency (the second term). It also shows that the higher the correlation between the foreign asset in local-currency terms and movements in the foreign currency, the greater the variance will be in local currency terms. (Again, take the square root and you’ll get the standard deviation.) Hedging away currency exposure will reduce risk, as measured by standard deviation–as can be seen in Exhibit 3 below. How does currency hedging work in practice? Most currency-hedged ETFs will use currency forward contracts to reduce their foreign-currency exposure. A currency forward contract is an agreement between two parties to buy or sell a prespecified amount of a currency at some point in the future (typically one month out in the case of currency-hedged ETFs) at an exchange rate agreed upon between the two parties. Because the value of the forward contract is fixed ahead of time, and the value of the fund will fluctuate during the course of a month as asset prices and cash flows into and out of the fund fluctuate, the forward may not be a perfect hedge. It’s also important to note that these hedges come at a cost, though their price tag typically amounts to just a few basis points in the case of developed-markets currencies in stable interest-rate environments. FX Effects It is useful to look at historical data to frame the effects of currency hedging on investment performance (for U.S. investors in this case). There are two key elements to consider when assessing the effects of currencies on equity portfolios: their contribution to return (as covered above) and their contribution to risk. Exhibit 1 shows “success ratios” for a trio of MSCI benchmarks over the 20-year period ended Jan. 31, 2015. These benchmarks are all tracked by one or more currency-hedged (and unhedged) ETFs. The success ratio represents the portion of the overlapping monthly rolling one-, three-, and five-year periods over these two decades during which the unhedged version of the index outperformed its fully hedged counterpart. For example, the MSCI EAFE Index outperformed its fully hedged counterpart in 59% of these overlapping rolling one-year periods over this 20-year span. In hindsight, in the case of the MSCI EAFE and MSCI Germany benchmarks, the winner could have been predicted by the flip of a (mostly) fair coin. The story is different when it comes to the MSCI Japan Index, where “getting the yen out” has clearly paid off more often than not. Exhibit 2 contains the annualized average returns for each benchmark across each of the overlapping monthly rolling one-, three-, and five-year periods dating back 20 years from the end of January 2015. The differences in relative performance vary between the hedged and unhedged versions of these indexes depending on the length of the measurement period. The MSCI Japan Index is again a unique case, as evidenced by the yawning performance differential between its hedged and unhedged versions. What about risk? Currency risk is a significant contributor to overall risk in the context of a foreign-equity portfolio. Exhibit 3 shows the trailing 20-year annualized standard deviations and Sharpe ratios for the same benchmarks featured in the first two exhibits. In the case of all three benchmarks, it is clear–as evidenced by the difference in Sharpe ratios between the U.S. dollar and hedged versions of the indexes–that currency exposure is a meaningful source of risk, currency hedging can serve to mitigate this risk, and it may ultimately result in superior risk-adjusted performance. To Hedge or Not to Hedge? The best answer to the question of whether it makes sense to hedge the currency exposure of an international-stock portfolio is this: It depends. By hedging foreign-currency exposure, investors can mitigate a source of risk–but at the expense of a potential source of return. The trade-off between the two is important, and investors’ decisions will depend on a variety of factors, including but not limited to their return requirements, risk tolerance, investment horizon, and the costs associated with hedging currency exposure. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Inside One Of Value Investing’s Greatest Minds: Walter Schloss

Computers, the internet, or even university are not needed to achieve fantastic investment returns. Walter Schloss had none of these, yet wracked up a 16% CAGR over 40 years. Investors will benefit enormously from adopting even a handful of core principles from Walter Schloss. Think you need an internet connection and instant data to make big returns in stocks? Meet Walter Schloss, one of the world’s best investors of all time, despite never having even touched a computer or the internet. With no formal qualifications, Schloss began working as a runner on Wall Street in 1934 before serving in the U.S. Army Signal Corps, and then eventually transitioning to the Graham-Newman partnership where he honed his craft. In 1955, Schloss founded his own firm: Walter J. Schloss Associates where he racked up one of the best records in investing history until his passing in 2012. When he decided to close his firm in the early 2000s, his record stood at a compound 16% per year – not bad for a 40 year career! It’s no secret why Net Net Hunter’s free net net stock picks emulate a lot of Walter’s investment approach. Walter Schloss Cornerstone: Book Value and Honesty Walter Schloss was a contrarian who based his value investing techniques on those developed by his mentor, Benjamin Graham. As Walter put it so simply, “we buy cheap stocks.” While the concept sounds overly-simple, Schloss does not mean buying up the cheapest stocks in terms of price. By cheap, Schloss is specifically referring to stocks that are selling below book value. “I focus on assets. If you don’t have a lot of debt, it’s worth something,” Schloss said in an interview he gave Forbes a number of years ago. Aside from buying firms below book value, Schloss also looked at the management of a company and whether they were overly greedy or honest. While he did not personally visit each company, being able to analyse how management ran the business over the years gave a good prediction on how the business will or will not prosper in the future. Ultimately, he found the combination of honest management and buying at a large discount to book value to be a very powerful combination. So have I, which is why a low price relative to net current asset value has become a core component of our Net Net Hunter Investment Scorecard . Walter Schloss Cornerstone: Own It While investing in stocks with honest management and a low price relative to book value was the key to Walter Schloss’ success, he also saw the importance of adequately diversifying his portfolio. Walter knew that predicting what a secondary company, the sort of companies in America today that wouldn’t be trading on the S&P 500, would earn was next to impossible so he stuffed over one hundred companies into his portfolio. In fact, if he saw a good opportunity, he just had to buy it. As he stated in an interview with the Bottom Line in 2003, “the important part is to have some money in the stock. If you don’t have any money in a stock you tend to forget about it.” Ultimately, you need to commit yourself one way or another in order to make money off of a stock. Being a contrarian, Schloss was also famously fine with Warren Buffett’s criticism that diversification was protection against ignorance. In fact, in Buffett’s famous talk, The Superinvestors of Graham-and-Doddsville, Buffett goes so far as to praise his stubbornness. “He owns many more stocks than I do – and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.” Walter Schloss Cornerstone: Stick to What You Know Investing has become far more globalized today than it ever has been. Today you can purchase a wide variety of stocks in Japan, Europe, Australia and many other countries, so long as you have a great international broker. The Japanese markets, specifically, offer fantastic opportunities . But, while Schloss believed in diversifying portfolios, he was apprehensive when it came to investing in foreign companies. He just did not understand the politics or the language of most countries so was not comfortable with the associated risks. This does not mean that Schloss was against international investments, however. In fact, Schloss purchased various British companies throughout his career. But what he was doing was focusing on decreasing his risks when value investing by only investing in areas that he understood and was comfortable with. If you speak and understand the culture and politics of another country and are comfortable investing there, then go ahead. However, like Schloss, if you are not comfortable and do not have a basic understanding of the area you’re looking at then it’s probably best to learn more before diving in, or just find other investments. Walter Schloss Cornerstone: Sell When the Time is Right One of the biggest challenges that any value investor faces is not knowing when to sell . It’s simple enough to tell which stocks are cheap on a statistical basis, and which have characteristics associated with outperformance, but knowing when to sell is another matter entirely. When you buy a depressed company it’s not going to go up right after you buy it, believe me. It’ll go down. And therefore you have to wait a while for that thing to go around. Schloss was once interested in a cement company named Southdown. He purchased a lot of stocks at $12.50 and in two years he doubled his money, selling the stock at around $30 a share. Schloss was happy with this result until he looked at the stock again some time later only to see that it had risen to $70 a share. Looking at the money that Schloss left on the table, it’s easy to assume that the smart move was to let his stock run up in price before selling. Schloss, though, always seemed to prefer a solid sale than holding out for greater gains that may or may not be realized. Ultimately, Schloss believed that if you buy cheap relative to value and then hold on long enough, a depressed company is bound to turn around and make you a decent profit. But selling at the right time does not necessarily mean selling after a specific gain has been achieved. In 1963, Warren Buffett came up to Walter Schloss and asked Walter if he wanted to buy a group of stocks that Buffett had originally picked up on the cheap. Walter, never one to pass up a bargain, snatched them up eagerly at around $14 each. He sold the majority of stocks from that group a little while later for a handsome profit, but ended up holding onto one of the firms, Merchants National Properties. Some time later he received a tender offer for the company at a price of $553 a share, further illustrating the fact that being patient does pay off. For Walter, the right time to sell was when the company was no longer cheap. When it comes to investing, there are few better to emulate than Walter Schloss. His investing style is as easy to apply as it is profitable. Investing does not take an enormous amount of skill. The right mindset and temperament, combined with some basic financial knowledge, will go a long way when investing. Keeping the investing process simple is the only way I’ve been able to wrack up a CAGR of +30% over the last 3 years. As Warren Buffett says, to be successful in investing it’s best to avoid complex business problems in favour of ultra-simple situations. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

A Stock Picker Establishing An ETF Portfolio: My Plans For A Roth IRA

Summary Building a global portfolio with ETFs within a Roth IRA. A “set it and forget it” portfolio to supplement individual stock picks in a taxable account. Diversification amongst sectors, market caps, geographical regions, and asset classes. With tax season around the corner, and as one of the lucky souls who will likely receive a refund this year, I’ve decided it’s time to consider funding a Roth IRA with the proceeds. My current idea is to build a “worry free” global equity portfolio with low-cost exchange-traded funds, coupled with a core bond holding to help smooth out volatility and build a source of income. Pruning the portfolio of individual stocks I consider myself a value investor at heart, with a soft-spot for dividend growth investing. My individual account is filled primarily with dividend-paying, large-cap blue chips. I’ve recently liquidated some positions (Kraft (NASDAQ: KRFT ), General Mills (NYSE: GIS ), Chevron (NYSE: CVX ), Exxon Mobil (NYSE: XOM ), and ConocoPhillips (NYSE: COP ), to be exact) in my portfolio since my last update , and I’m now holding 23 companies. I decided to limit my exposure to some overvalued, highly-leveraged staples, due to my previously overweighted exposure to the sector. I’m also primarily “ex-oil” at this point, with the exception of BP (NYSE: BP ), which I still think has some value left. I decided to limit my exposure to oil despite considering Chevron as a “top pick” in the beginning of the year, because I’m not convinced oil will double to rebound near $100/barrel anytime soon, and despite much lower earnings prospects, the companies I once owned still trade near where they did when oil was much, much higher. I believe a time will come when I will be able to buy them back at much better prices. Most of the proceeds were rolled into Disney (NYSE: DIS ) and Gilead (NASDAQ: GILD ) pre-earnings, with the rest used to re-establish a position in Cisco (NASDAQ: CSCO ) and add to an existing position in Microsoft (NASDAQ: MSFT ), after a large, earnings-related sell-off. MetLife (NYSE: MET ) was also added, and I plan to continue to gobble up shares of cheap financial companies as the Fed prepares to raise rates. A paradigm shift After “cutting the fat” and changing my view on oil so suddenly, I decided that maybe I should “hedge my bets” a little by dedicating some capital to more passive investments. Sure, I’m doing fine so far with my picks while building a nice stream of dividends, but what if I’m not always so lucky? I also noticed that I was invested mostly, if not only, in large to mega caps within the U.S. as well, which may not necessarily be a bad thing. In today’s market environment, these types of companies tend to outperform, but this may not always be the case if rates normalize and bonds start paying respectable yields again. Then small caps may see their time in the sun again as well. So the first ETF I am considering will include smaller companies. The U.S. equity portion For the domestic portion of my ETF portfolio, I am currently considering the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). This fund has a rock-bottom expense ratio of just 0.05% and covers a wide spectrum of U.S. stocks, including a 6.5% exposure to small caps and a 19% weighting assigned to mid caps. To complement VTI, I plan to add an allocation to real estate with the Vanguard REIT ETF (NYSEARCA: VNQ ). This will add another layer of diversification to my Roth IRA, as well as a higher yield of about 3.37% to offset the miniscule yield of roughly 1.88% offered by VTI. I plan to equally weight these two ETFs, and together they will compose about 36% of the overall portfolio and half of the overall equity portion of the portfolio. Moving overseas To gain exposure to international equity markets, I plan to equally weight the Vanguard FTSE Developed Markets ETF (NYSEARCA: VEA ) and the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ). These two funds will fill the other half of my equity allocation within my Roth. VEA carries a low expense ratio of 0.09% and VWO’s expense ratio sits at 0.15%. VEA gives me exposure to Europe, with core holdings such as Nestle ( OTCPK:NSRGY ) and Novartis (NYSE: NVS ), as well as Japanese markets with companies like Toyota (NYSE: TM ). Japan, the United Kingdom, and Switzerland make up half the geographical allocation of the fund, with countries like Germany, Australia, and other developed markets making up the rest. To offset slower-growing foreign markets, VWO offers more risk and potentially more reward, with over 20% of the weighting placed in China and almost 12% exposure to India. These markets should continue to grow at a rapid pace, and this fund gives me lower-risk exposure to this growth without the headaches of selecting individual companies in these countries. Holding my nose and buying bonds The last ETF I plan on adding to my Roth to round out the overall portfolio is the Vanguard Total Bond Market ETF (NYSEARCA: BND ). This will be my first foray into bonds, and I think this fund is a good anchor to begin the process of establishing an allocation to fixed income. The fund tracks the performance of the Barclays U.S. Aggregate Float Adjusted Index. The reason I selected this fund is due to its lower expense ratio of just 0.08%, as well as its lower duration of roughly 5.6 years. The low expenses are extremely important for a bond fund, and the low duration is important to limit risks related to rising interest rates. The fund also holds only high-quality bonds credit-wise with about 42% of the fund in investment-grade government bonds, roughly 23% in investment-grade corporates, and 20% in agencies. BND will be the anchor of my fixed income allocation for now, and when rates do begin to normalize, I may consider extending the duration and increasing the yield of my overall bond portfolio. I’ll accomplish this by adding shares of the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ), and then even longer-dated treasuries with the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ). BND will account for about 27% of the overall portfolio, equal to my age of 27 years old. Conclusion Once funded, I plan to add these 5 ETFs to my newly established Roth to offset some of the risk of the individual stocks in my taxable account. As a retirement account, I want a globally diversified equity portfolio, anchored with investment grade bonds with only moderate exposure to rising rates. I believe the above-mentioned funds can achieve this goal in a simple, cost-effective way, and also in a way that allows me to easily rebalance if need be. While this ETF portfolio may be far from perfect, and now may not be the optimal time to be buying into these funds, I have a 30+ year timeline to let them marinate. I plan to rebalance at least annually as well. I also plan to shift more towards bonds the older I get, essentially creating my own “target date” fund. I decided to write up this portfolio concept to share it with the Seeking Alpha community, hopefully receiving some constructive criticism along the way. What do you think? Please let me know in the comments section below. Disclosure: The author is long BP, DIS, GILD, CSCO, MSFT, MET. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Articles I write for Seeking Alpha represent my own personal opinion and should not be taken as professional investment advice. I am not a registered financial adviser. Due diligence and/or consultation with your investment adviser should be undertaken before making any financial decisions, as these decisions are an individual’s personal responsibility.