Hedging the US Dollar in the “Basic Plan”

Recently the US dollar has strengthened against most foreign currencies.  This means that you could buy foreign stocks and they could do well in their local markets (for example, the Japanese stocks were generally up for a time) and yet you would have losses when your ADR or ETF was valued in US dollar terms.

While you cannot generally hedge the currency risk in a single stock ADR (for example, Toyota), they now offer ETF’s that give exposure to foreign markets but also hedge those currencies against the US dollar, so you receive their “actual” return (good or bad) rather than their actual return PLUS the impact of the rising or falling US dollar.

For instance, let’s look at the VEU Vanguard ETF (one of my favorites, the Red line below) against a new ETF I started looking at, HEFA (the Blue line), over the last two years.  You can see that the total return was 1.1% positive in HEFA and 14.2% negative for VEU over that time span.  This difference is due almost totally to the rise in the US dollar against foreign currencies that make up the bulk of those stock indexes (the Euro, the Japanese Yen, the Australian Dollar, and the Canadian Dollar).  You can see that the peaks and valleys of the blue and red lines track together (they move in the same direction) but the red line sinks as the US dollar rises over the last two years.

 

VEU vs HEFA Last 2 years
VEU vs HEFA Last 2 years

One negative impact of this, all else being equal, is that hedging costs money and this should be expected to drive up fees on your ETF.  The ETF for Vanguard (VEU) is 0.14%, which should be considered somewhere near rock bottom.  The HEFA ETF expense ratio is 0.35%, which is also very low, but higher than the Vanguard product.  This isn’t a perfect comparison because generally the Vanguard ETF’s have the lowest expense ratios due to their member-owned structure.  HEFA is part of iShares which is now owned by Blackrock, a major competitor of Vanguard.

It should be noted that the VEU and HEFA indexes aren’t exactly the same in terms of countries that they cover and weighting of markets but as you can see above they generally move closely in tandem and the majority of the difference is due to the impact of the US dollar against foreign currencies.

This is of interest because the US Federal Reserve is considering raising interest rates soon, which theoretically would cause the dollar to rise which would make holding shares in other currencies less profitable.  Of course this is already priced into the dollars’ current level, which could mean in practice that if the Fed doesn’t move fast enough or make enough moves, the dollar would fall.  If anyone ever tells you that they can predict interest rates or currency moves you should not believe them; there is no reliable way to predict either one although there are mass industries of pundits attempting to do so.

Thus for my “basic plan“, the question is, should you also consider adding currency-hedged ETF’s and not just the two basic ETF’s (VEU and VTI).  The question is whether to replace part of your VEU allocation (how much you buy) with something like HEFA (there are other ETF’s, but this seems to be a pretty good one, with a large base of investors and from a company like Blackrock which isn’t going away any time soon).  Here’s what would happen – if the US dollar falls against major foreign currencies, you are going to make less money than you would otherwise if you hedge it.  If the US dollar rises, you will make more money than you would otherwise with the hedged product.  Also note that the hedging may not be perfect, but would likely shield you from the vast majority of the impact, especially on major currencies like the Euro.

I think that this is getting a lot of play in the financial press right now and I predict that at some point these products will be mainstream.   It took a long time to move from “active” to “passive” investing and it has taken many more years for ETF’s to begin to take a large share of new investments away from mutual funds.  This is another long term trend that started on the margin (there were very few currency hedged funds a couple years ago when I looked, and they were expensive) but is now going mainstream, and the additional expenses for hedging seem quite modest (0.14% vs. 0.35%).

Relative Performance

As we start to select potential stocks for the summer it is useful to see how the various US sectors have performed so far in 2015.  We can see some of the winners and losers in our own results but it is useful to view it across all the sectors broadly, even those sectors where we have less exposure.

US_Sectors_YTD

In addition to looking at US performance, it is useful to review performance of some economies where we have stock selections, notably Canada (many banks, utilities) and Australia (banks and natural resources). These stocks seem to be doing reasonably well on their own exchanges, down 3-5%, when denominated in local currency.

Australia_Canada_Local_CurrenciesHowever, when these results are converted into US dollar terms, they look much worse.  For a while the Canadian and Australian dollars were near “parity” with the greenback… since then they have fallen significantly.

Australia_Canada_US_Dollars

It is important to take into account sector performance and the US dollar vs. specific other companies currencies.  These elements are very impactful, along with the individual stocks selected.  You can always pick a stock that will go far above or below the trends of its sector and / or currency, but in general these are strong forces and most sector and country selections have a solid correlation in terms of outcomes.

The Liquidation of Markets

Every weekend I read Barry Ritholtz’s recommended reading and there are a lot of gems in there. Recently he posted this Credit Suisse graphic about markets at the turn of the 20th century by market share and compared it with 2014 on the topic of global equity investing.

US_stocks

In his article he mentioned the fallacy one might fall into as a UK equity investor in 1899… why bother investing in the USA when the UK market is so much larger? And then this line of thought ends up missing the huge growth in US market share over the next century.

However, the real issue here isn’t the relative change in market share by the different countries; it is the fact that almost all of these markets were entirely extinguished at one time or another by political, economic or military events that wiped out the investors.
Continue reading “The Liquidation of Markets”

US Markets vs. The Rest of the World

Although the US stock market has pulled back a bit as of late, we are up over 10% in the year to date. The rest of the world with the exception of the US, however, is actually down about 1% or so. The Vanguard ETF VEU is a decent, simple proxy for the rest of the non-US market (although any single measure is flawed). I started using an average of the US markets and the VUE to compare against the trust funds documented in this blog (see funds 1-5 plus newly started 6 in links to the right) because it is a more applicable mix since 30-50% of the assets are in non US stocks (ADR’s).

There are two main components for the foreign markets right now

1) their currency against the US dollar
2) their market index performance

The US dollar has strengthened against many of the foreign currencies, which means that US assets are worth more and foreign assets are worth correspondingly less. We recently looked at the impact of this on the Japanese markets, where strong growth in local currency (the Yen) didn’t translate to increases in value of stocks to US citizens (unless you bought from an ETF or mutual fund that hedged the dollar / yen exposure to stay neutral, which most of them do not).

Many of the foreign indexes have declined, and European stocks in general have not recovered from the 2007-8 crash to the same extent as the US market did. A simple rule is that anything (in the US) bought in 2006-7 near the peak was way overpriced and anyone who bought during the trough in 2008 when the markets were in their nadir did very well. This rule generally applied overseas as well but some markets didn’t come back as strongly.

Every country is unique as is their impact on the markets. There have been riots and other acts of instability in emerging markets. However, it seems that the moves of the US to perhaps reduce “quantitative easing” by the Fed (QE1-3…) that are spooking the foreign markets, since a rise in the value of the US dollar and interest rates is thought to have a major impact on the relative attractiveness of these foreign markets. Today the world benefits from low interest rates and it is anticipated that at some point these low interest rates will rise and it will have various (mostly negative) impacts on countries and currencies around the world.

Investing is very complex and this blog highly recommends that you do your own research. The point of this post is that in order to judge performance you need some applicable benchmarks and if over 30% of your portfolio is in non-US assets you can’t judge against a US benchmark. You also need to understand not only the performance of the overseas markets but also the performance of their currency vs. the US dollar.

Low Interest Rates and Side Effects

I was recently at a bank as part of a non-profit (else I rarely step foot in a bank) when I was talking to the banker about setting up a new account and we started discussing the interest rates that each of the potential accounts would receive.  After a bit of discussion I said

At these rates, it doesn’t matter

Basically interest rates on savings accounts and non CD accounts are effectively zero unless you have an immense amount of money in that account.  For example, the Chase “savings” account offered .01% – which means that if you have $100,000 in the account all year long, you are going to make $100.  That is the definition of negligible.  Certainly you can shop around a little more and get a higher interest rate, but you aren’t going to get near 1% unless you buy some sort of vehicle with other conditions (i.e. locking up your money for a period of time).  The woman at the bank was apologetic but I knew that there was no reason for her to be – it wasn’t her fault that the nation had undergone a massive ZIRP experiment.

One side effect is that banks have now effectively become a vehicle for 1) making transactions 2) providing services.  They are no longer really a vehicle for making money (i.e. earning interest, especially compounded interest, that is meaningful over time).  Thus your money now is more of a way to avoid charges on those services (free checking, or avoiding low balance charges, or access to certain types of transactions without fees) than a means of making money.

The traditional function of banks is to take your deposits and turn around and “leverage” that money to make loans to others.  Since banks can count on not everyone to show up and demand their deposits back on the same day (unless there is a bank run), and they should be able to earn money on the difference between the cost of the money to them (they can borrow at the lowest rates) and what they charge loan customers, this should fund much of their profits.

The newspaper industry is dying because they provided journalism as a service but made their money selling advertising (effectively as a local monopoly for many years).  When businesses and individuals stopped buying advertising (hello, Craigslist), the “service” that they provide, journalism, had to pay the bills.  As a result this industry has gone into free fall since then.

Banks and many other financial institutions generally do a lot of services but make their money on the spread between what they pay you and what they pay for interest in terms of their cost of money.  Then they take that difference and it generally subsidizes everything else.  If that difference becomes negligible, then the financial institution has to make money in some other manner, or see their profits wither like the newspaper industry.

With interest rates so low and money washing into their doors, banks should be able to make up for everything on loans.  However, everyone is conservative about loaning money right now unless it is secured, and the home equity loan pipeline has mostly dried up since many houses have lost their equity buffer.  I don’t have direct experience with this but have heard that it is generally not easy getting a business loan, the type of loan that is riskiest unless it too is essentially secured in some other manner (property, receivables, etc…).

As a customer, if in the medium to longer term, if you assume that interest rates will stay very low, then you have options that you probably wouldn’t have considered otherwise.  For one – you may just want to consider taking a portion of your money out of the bank and just convert it into gold in your safety deposit box.  The biggest argument against gold historically is that it doesn’t produce a return – it just sits there, and has storage costs to boot.  While both items are true, a safe deposit box is cheap to rent each year (mine is about $100) but on top of it keeping your money in a financial institution has transaction costs, as well.  You can do the same thing by buying GLD the Gold ETF which may have other advantages with regards to transaction costs and sales taxes

Another alternative is to purchase foreign currency and put it in your safe deposit box.  This traditionally has been a terrible strategy because it earns nothing but in an era of almost zero returns on major currencies around the world the side effects of this strategy are lessening almost by the day.

Since the banks can only make so many loans that are basically secured and there hasn’t been a lot of impetus by them to move into more risky types of business loans, they are basically awash in cash.  In some circumstances, they have considered paying negative interest rates for large blocks of cash, and this has happened with short term debt instruments quoted in some markets, as well.

The last part of this is to strip the concept of “compound interest” out of your heads.  One of my blogs is for teaching kids about investing and if I was starting this years ago I would have made a big pitch for the advantages of investing your money for long periods of time and watching it grow with the “magic” of compounding interest.  It is hard to make this case with interest rates far below 1% unless you have large quantities or buy specific vehicles which take you near 1% and even that is a gigantic time frame to “double” your money.  If you assume 1% / year then it takes about 70 years (give or take) to double your money – better than the straight-line model of 100 years but in all cases virtually irrelevant for practical purposes (nice calculator here).

Thus some interesting side effects for me are

1) the lost “opportunity cost” of holding cash in gold is now negligible

2) the lost “opportunity cost” of physically holding non-US currencies is now negligible

3) the margin that financial institutions receive on interest is now very low and they will need to either expand into riskier non-secured loans (which they haven’t done) or start charging for services and transactions (or see their margins crumble)

4) with 3) above and interest rates near zero the real “value” of your money with the bank is in avoiding / minimizing transaction costs and being able to take advantage of better services 

5) the concept of “compounding interest” is basically dead on risk-less instruments, and for riskier instruments it is but one component of total return (probably the least essential component)

Cross posted at Chicago Boyz

 

 

NYT Article on Emerging Market Bond Mutual Funds

Recently I wrote about ETF’s for international bond funds that are denominated in local (non US Dollar) currencies.  The NYT in their Sunday edition had a mutual fund report (they still segregate mutual funds from ETF’s, even though they are generally substitutes for one another) that discussed a similar tactic called “Emerging-Market Bonds Quench a Yield Thirst“.  This article is focused on emerging markets (like Brazil and China and the Asian countries) rather than the developed markets that those ETF’s target.

The article approaches foreign bonds as a way to achieve a higher yield (interest income) since US interest rates are minuscule.

With the measly yields now offered on presumably safer bonds, like United States Treasuries, savers are seeking more appealing sources of income.  And in the first quarter this year, the average emerging-bond fund tracked by Morningstar returned 7 percent, versus 0.3 percent for the Barclays Capital US Aggregate Bond Index.

The article gets more sophisticated but this is a “classic” case of confusing risk and return.  The return on emerging market debt SHOULD be substantially higher than for less-risky debt, assuming that US debt is actually less risky.

The relative risk of emerging markets compared with developed markets has changed… The average debt level of emerging market countries like Brazil and China is far lower than that of developed ones like the United States and Japan… emerging economies have continued to surge even as much of the developed world keeps struggling with the aftermath of the 2008 financial crisis.

That’s true.  If you ignore the complexities of legal systems and whether or not a country like Brazil or China would default if it was in their best interests to do so, by statistics alone they are superior to the developed world.  Having a modern legal system and being tied to the West didn’t save Greek debt holders from having to take a 75% loss on principal, after all.

The article goes on to describe two key differences – bonds issued in US dollars (“dollar bonds”) and those that invest in bonds denominated in local currencies.  In the previous article on foreign ETF’s I covered Germany, Canada and Australia – those countries would not offer bonds denominated in anything but their local currencies (Euro for now, Canadian dollar, and Australian dollar) but for emerging countries often the debt is denominated in some other currency which makes it more palatable to investors, particularly non-local investors.

If you denominate an emerging market bond in US dollars, then that has the same effect as “hedging” your bond portfolio against fluctuation in the local currency against the dollar, which is a frequent practice for many mutual funds because investors wanted purely the higher yield (and theoretical increase in risk of principal loss that come with this) and didn’t want to also add in the “currency risk” of fluctuations against the US dollar.

Whether the mutual funds invest in “dollar bonds” or bonds denominated in local currency will impact the potential returns of the fund as well as the riskiness of the assets in the fund (likelihood of default).  Per the article many of the funds operate a “mix” of these strategies, which may mitigate some risk (dollar bonds may be issued by more solvent issuers and also don’t have currency risk) but likely leaves some yield “on the table” from local issuers willing to pay a higher rate in local currency as well as the potential gain or loss on fluctuations from the local currency vs. the US dollar.

In the US, corporations mostly go to the public corporate bond market for funding, whereas in emerging countries companies often go to local banks (and Europe is somewhere in the middle).  Since so many companies in the US rely on markets for debt funding, the overall market is (relatively) liquid and large in size, and as a result there are many metrics to track and there is a long history of data to review.  In developing countries, the corporate markets aren’t very deep, and those that do issue debt rather than going to banks often issue it in “dollar” bonds instead of local currencies.  Per the article:

Local-currency corporates exist in Brazil, but the market isn’t very deep… in a less mature market, he might stick with dollar issues.

Compared to the total universe of mutual funds and ETF’s, the portion that is tied to

  • emerging market debt
  • has bonds denominated in local currencies and / or “dollar” bonds
  • has a liquid enough market to make sense
Is still very low compared to the vast universe of mutual funds and ETF’s that cater to US based debt obligations.  However, this is a growing market as investors
  • Shy away from the pitifully low yields offered from US entities
  • Realize that the credit quality of the US (recently downgraded) and many states (such as Illinois, which is in dire financial straits) is not what it used to be
  • Realize that the US dollar has been in a long term decline over many decades against many major currencies and by being substantially invested in US dollar denominated assets they are in effect losing return when compared against foreign based assets (even though it doesn’t show up directly in the US dollar based financial statements)
I am still researching these areas for my personal investing and learning more about 1) the markets 2) how the mutual funds and ETF’s are structured 3) how currency risk is managed or not managed (hedged) within each of the financial instruments 4) the types of instruments that each fund is holding and the benchmark that it uses to determine success.  Specific mutual fund companies that offer these funds include JP Morgan, Barclays, Power Shares, iShares, and others.
Another item to note is whether the financial instrument is an ETF or a mutual fund.  ETF’s generally (but not always) avoid capital gains and losses being pushed to you annually and you can defer them until the instrument is bought or sold on an exchange, which is generally more tax efficient.  You can learn more about the particular instrument that you are considering buying by looking to see their pattern of historical distributions and whether or not they have paid capital gains.
Cross posted at LITGM

Researching Foreign Bond Funds (ETF’s)

Recently I have been evaluating my total portfolio in terms of US dollar exposure.  Traditional (primitive) metrics of portfolio evaluation picked concepts like

  1. Splitting your portfolio between cash / bonds / stocks / real estate
  2. Splitting your stock portion between US and foreign stocks
  3. Breaking down your stock exposure into industry sectors like technology, finance, consumer products, etc…
  4. Adding a category for commodities, generally broken down between the precious metals (particularly gold, which had a huge run up) and everything else (oil, grains, metals, etc….)
  5. Reviewing your investments in terms of yield whether it is measured in interest return (bonds, REITS) or dividends (stocks)
  6. Categorizing your investments by “tax efficiency”, which favors municipal bonds (which are exempt from Federal and often state taxes) and currently dividends (taxed at a 15% rate) but punishes normal interest which is taxed as ordinary income
  7. Splitting your personal portfolio into “retirement” funds which generally are invested without paying taxes, grow (hopefully) over the years with reinvested dividends and interest, but are taxed when you retire and start taking withdrawals, from “non-retirement” funds which are subject to current taxation on dividends and interest but whose “basis” or original investment value have already been taxed.  A third category is Roth investment vehicles which are taxed now but the gain or loss above the current value is not taxed when you take out funds upon retirement

These concepts are all useful ways to review how your money is being allocated across all these sectors of investing.  There is no “one” right way to allocate your portfolio or to even assess how your portfolio is currently deployed.

On the topic of bonds, to me they traditionally represented 1) primarily a vehicle to earn interest, with the rate of interest dependent upon the riskiness of the bond 2) a (relatively) secure means of investing meaning that you expect to get your principal back (i.e. if you invest $50,000 at 2% which unfortunately would be a great rate now you pretty much are focusing on earning $1000 / year in interest and ultimately getting back your $50,000 when the bond matures).

However, the general perception that the bond world is “safe” doesn’t jibe with events that have occurred over the last decade or so.  These events include:

  • The massive budget deficits being run by the major world democratic powers in the US and Europe both at the Federal and regional / local levels, which are unsustainable as we found out in Greece and are likely to find out in many other places to come
  • The decline of over 30% in the US dollar against other currencies over the last few years, caused by many factors but primarily our low interest rates and a semi-deliberate policy of devaluation
  • My personal local exposure to government entities in Illinois at the state and local level (Illinois has the worst state credit rating in the US, and Cook county and the city of Chicago are famously corrupt) which leads me to expect the worst from the municipal bond market

These factors caused me to begin researching foreign bond funds.  My goal was to find foreign bond funds that are

  1. From countries with a reasonable prospect of being stable and paid back (i.e. not Greece or countries with no track record)
  2. Denominated in a currency that is not US dollar based that is likely to be around in the future (i.e. Canadian or Australian dollar, the Asian currencies, etc…)
  3. Put into a fund that doesn‘t HEDGE vs the US dollar – many overseas bond funds hedge against the US dollar so although you get foreign investment exposure in terms of returns and risks, you still are based on the US dollars gains and losses over time.  This is new because until recently most of the funds I can find tended to hedge currency exposure
  4. Have a low cost of ownership; preferably as an ETF which doesn’t (generally) incur capital gains and losses on a given year; these changes are “baked” into the share price which fluctuates over time and then you can choose when and how to incur the gain or loss by selling shares rather than being forced to book the gains or losses each year depending on fund activity

I briefly considered buying individual foreign bonds but this required a lot more work and understanding than I was prepared to do.  This may be something I’d consider in the future but since I don’t want to be consumed in research and exposed to unknown IRS forms and risks (since we do our own taxes and direct our own investment) for now I was looking at something less complex.

While it may seem that a lot of individuals are thinking the same things as me (the above thoughts are pretty obvious) sometimes you have to “wait around” for the industry to come to the same conclusions.  I bought the first dividend-focused ETF (DVY) when it came out and was waiting for a while to find it (and I heard about an early cash-back credit card and was an early adopter of this, as well).

PIMCO recently seemed to have what I was looking for when they released three new ETF’s.  The ETF’s are for Australia, Canada and Germany.  Here is a link to the PIMCO web site describing these three investment opportunities.

 PIMCO recently introduced three country index exchange traded funds (ETFs) focused on enabling investors to capitalize on the investment opportunities in Australia, Canada and Germany. PIMCO believes these three countries have balance sheets and debt dynamics that are well positioned in the global economy, considering the potential for slower growth and ongoing deleveraging, and offer important diversification of currency exposures for U.S. investors.

This description from their web site has what I am looking for:

  • Countries whose debt load appears sustainable or well managed
  • Non US currency exposure THAT IS NOT HEDGED
  • In ETF form to limit annual capital gains and losses but allow you as the investor to choose the time for “harvesting” your gains and losses
  • A reasonable level of total expenses, which are incredibly important for interest bearing instruments at a time of low interest rates (they are 0.5% for the Australian bond fund, which is still on the high end for me)
  • A reasonable level of asset size is desired so that the ETF doesn’t behave erratically or face the possibility of closure (sometimes ETF’s are closed and money is given back to investors).  It helps that PIMCO is huge and if they are likely to move into a sector like foreign bond ETF’s they wouldn’t seem likely to just shut down a fund if it grows more slowly than anticipated
  • Australia in particular offers yield (investment return) much higher than US bonds; they currently are above 4% when you’d be lucky to get 2% in US equivalent Federal debt right now.  This of course is factored into the currency level vs. dollar (it is high now) so in some “grand equilibrium” scheme they may or may not be in balance; but in the short to medium term it is fair to say that Australian debt “yields” more than US equivalent debt

In my investing I generally try not to anticipate specific events but rather to have a broader and more diversified spread on investments.  From a currency side, you have the Australian dollar, the Canadian dollar, and the Euro.  The Australian and Canadian dollars have had a huge run-up against the US dollar, which would make someone “chasing return” salivate, and the Euro faces downward pressure for many reasons most notably the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and their expanding financial difficulties and deficits.  However, the game ahead is very long, and anyone that can reliably predict the trend of currencies against the US dollar wouldn’t be writing a blog like this or even commenting on it, they’d be in a giant private jet flying to their giant private island because that is an exceedingly difficult or possibly impossible thing to do.  And even if the Euro goes kaput, a German focused fund would convert into the new German currency, which would be predicted to be among the best currencies of the broken-up Europe.

I will look at these three funds in detail and likely buy ETF’s in them which will 1) be in the bond class 2) hold a reasonable prospect of continued repayment 3) provide non US dollar diversity.

Cross posted at LITGM