The majority of our clients’ separately managed equity portfolios are invested in high-quality, large-cap stocks listed in the U.S. For many clients, however, we do invest small positions in exchange traded funds in order to provide exposure to companies in attractive foreign markets. We have chosen to buy ETFs instead of directly owning foreign securities or mutual funds for a number of reasons. Mutual funds tend to be relatively expensive (particularly ones that invest in foreign markets) and they have bad tax consequences for investors’ taxable assets. Foreign securities can be logistically difficult to buy and sell in a timely way, and they involve complexities of currency translation. Therefore, we tend to prefer ETFs, since they’re relatively inexpensive and liquid.
Our principal international ETFs at the moment are the following five:
- iShares Mexico (EWW)
- iShares Phillipines (EPHE)
- iShares South Korea (EWY)
- WisdomTree European Hedged Equity (HEDJ)
- WisdomTree Japan Hedged Equity (DXJ)
Among others, we used to own the iShares Swiss country fund. The performance of this fund over the past week or so shows dramatically how although ETFs may make foreign markets more accessible, they don’t eliminate currency risk — or reward. When the Swiss National Bank abruptly ended its policy of buying euros with Swiss francs at a fixed rate of 1.2, the price of Swiss francs soared, both against the euro and the dollar. (The Swiss central bank had been artificially suppressing the strength of the franc relative to the euro in order to benefit Swiss exporters who sell to the eurozone. An expensive franc makes their exports more expensive for eurozone consumers to buy and therefore hurts demand.) The franc’s price swing at one point topped 40%.
Although the subject seems arcane and removed from ordinary economic life, the sudden appreciation of the franc was a portentous event. As a number of commentators have pointed out, a 40% intra-day price swing in a major global currency is a genuine “black swan” occurrence, and it shows the degree to which central banks’ interventions are artificially distorting the market’s pricing mechanism. Even as Switzerland’s export-oriented stocks tumbled with the end of the currency peg, US dollar-denominated Switzerland stock ETFs surged.
Two of the international ETFs we currently own involve currency hedging: WisdomTree’s European Hedged Equity and Japan Hedged Equity. In a normal market environment, we wouldn’t want to own currency-hedged ETFs. Hedging is expensive, might not work, and can produce taxable short term gains even when it does. (Thus far it has worked for us, however, particularly in the case of Japan.) If you’re investing in a market that is growing and healthy, the appreciation of its currency relative to the dollar is something that you want to own along with that market’s productive, quality companies. But in an era of central bank currency manipulation, the normal rules sometimes don’t apply. The central banks of the developed world have been engaged in sequential competitive currency devaluation. They don’t call it that, but that’s what it is, especially in the case of Japan, Switzerland, and now as of this week, the European Union. Although the US Federal Reserve ceased its “quantitative easing” program last year, Japan has kept its up and the European Central Bank just announced a larger-than-expected bond-buying program.
There’s no clear evidence that Europe’s QE program will help, but there’s plenty of evidence that it will make investing more difficult.