Horizon Investments of Charlotte, NC, is one of the many companies providing us with investment research, and a fine example of their excellent work is in a May 12 research report containing the following graph:

The message is very clear: Over the last three years, approximately one fifth of all the returns in the iShares EFA Fund have come from currency movements. If you owned the underlying companies in the EFA iShare, and hedged the currency exposure, you would have earned a cumulative return of nearly 40% over this period, 10% less than the return of 50% earned by owning the EFA. Moreover, currency exposure is highly concentrated, with over 80% of the EFA denominated in Euros, Pounds, and Yen.

We spoke with Jeffrey Roach, Chief Economist at Horizon, who provided some insights behind the data.

Roach says this phenomenon is not generally well-known or understood. “Most of what you are seeing here is due to the dramatic and consistent depression in the value of the dollar relative to other currencies,” says Roach. He believes many investors do not appreciate the role of currencies in a diversified ETF holding, as compared to a much less diversified actively managed non-US mutual fund.

At least two academic studies have looked at this issue, and both show that currency effects have not always dominated. The first study, The performance of Currency-hedged Foreign Equities, by Lee Thomas, looked at a portfolio of equities in developed economies from 1975 to 1988. Annual returns from an un-hedged portfolio were within 0.1% of the returns of a portfolio hedged to the U.S. dollar over that period. The second study, Asset Allocation with Hedged and Unhedged Foreign Stocks and Bonds, by Phillipe Jorion, looked at stocks in the EAFE index (which is the basis for the EFA ETF) from 1978 to 1988 and found the difference in hedged versus un-hedged returns was 2.0% annually over that period.

Times have changed, and the volatility of the currency markets now dominates the behavior of diversified funds such as the EFA. This explains in part why funds that have hedged their currency exposure, such as the Tweedy, Browne Global Value fund (TBGVX) have underperformed the EFA over the last three years.

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