Currency-Hedged EAFE ETF Outperforms Unhedged Version by 3% Annually Over Past Decade

For U.S. investors seeking international diversification, the impact of currency fluctuations can be a hidden but significant factor in portfolio returns. Over the past ten years, the iShares Currency Hedged MSCI EAFE ETF (HEFA) has outperformed its unhedged counterpart, the iShares MSCI EAFE ETF (EFA), by an average of 3 percentage points annually, according to data from iShares. This performance gap underscores how currency risk can erode-or enhance-returns when investing in developed markets outside the U.S. and Canada.

Both HEFA and EFA track the same underlying stocks across Europe, Japan, and Australia, but only HEFA uses currency contracts to neutralize the impact of exchange rate movements. For investors holding EFA, a strengthening U.S. dollar reduces the value of foreign holdings when converted back to dollars, while a weakening dollar has the opposite effect. Over the past decade, the dollar has generally appreciated against major currencies, amplifying the advantage of currency-hedged strategies for U.S.-based investors.

How Currency Hedging Works

Currency-hedged ETFs like HEFA use derivatives to offset the impact of currency movements relative to the U.S. dollar. This approach aims to isolate the performance of the underlying stocks, allowing investors to benefit from equity returns without the added volatility of fluctuating exchange rates. In practice, this means that HEFA's returns more closely reflect the local market performance, while EFA's returns are a blend of stock gains or losses and currency effects.

According to iShares, currency hedging reduced volatility by roughly 10% over the past decade compared to the unhedged version. For example, a $10,000 investment in HEFA ten years ago would have grown to about $32,700, while the same investment in EFA would have reached approximately $25,000. This $7,700 difference highlights the cumulative impact of currency risk over time, especially during periods of sustained dollar strength.

Risks and Trade-Offs for Investors

While currency hedging can reduce volatility and protect against a rising dollar, it is not always the optimal choice. If the dollar weakens, unhedged funds like EFA may outperform, as foreign currency gains add to investment returns. Hedging also introduces additional costs, which can slightly reduce returns in periods when currency movements are neutral or favorable to U.S. investors. The decision to hedge depends on an investor's outlook for the dollar, risk tolerance, and investment horizon.

Expense ratios are another consideration. As of early 2024, HEFA's net expense ratio was 0.35%, compared to 0.32% for EFA. While the difference is modest, it can add up over time, especially for large allocations. Investors should also be aware that hedging strategies may not perfectly offset all currency risk, particularly during periods of extreme market volatility or when hedging instruments do not track currency movements precisely.

Comparing International ETF Strategies

For those seeking exposure to developed markets, the choice between hedged and unhedged ETFs is not just about returns-it's about risk management and investment objectives. Currency-hedged funds offer a more direct play on foreign equities, while unhedged funds provide exposure to both stock and currency movements. This distinction is especially relevant for investors who want to avoid unintended bets on the direction of the dollar.

Many investors assume that international ETFs are automatically diversified, but concentration risk and currency exposure can still play a major role. As discussed in this analysis of sector ETF concentration risk, understanding the underlying structure of a fund is essential to managing portfolio risk. The same principle applies to currency exposure: knowing whether an ETF is hedged or unhedged can have a material impact on both returns and volatility.

Currency risk is a persistent factor in global investing. While hedged ETFs like HEFA can help U.S. investors focus on the performance of foreign stocks themselves, they are not a one-size-fits-all solution. The choice between hedged and unhedged strategies should reflect each investor's goals, time horizon, and views on currency trends. For those who want to minimize surprises from exchange rates, currency-hedged funds offer a practical way to manage risk, but they also come with their own costs and limitations. Understanding these trade-offs is key to building a resilient international portfolio.