The Hidden Cost of International ETFs: How Much Currency Risk Actually Ate Into Returns Over the Last Decade

The iShares MSCI EAFE ETF (NYSEMKT: EFA) and the iShares Currency Hedged MSCI EAFE ETF (NYSEMKT: HEFA) are essentially the same portfolio and hold the same developed market stocks across Europe, Japan, and Australia. The only structural difference is their currency exposures. The first allows currency swings and accepts whatever effect they have on total returns. The latter strips out that currency risk.

Either one can work. It just depends on which risk exposure you prefer, and if you have a high conviction opinion as to whether the dollar will add to or reduce performance. Over the last decade, that difference between hedged and unhedged could have been worth thousands of dollars.

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EFA vs. HEFA: How they're constructed

The iShares MSCI EAFE ETF tracks the MSCI EAFE Index, which consists of more than 700 large- and mid-cap stocks across developed markets outside the United States and Canada. Returns reflect both changes in the values of the underlying stocks and fluctuations in the euro, yen, pound, and other currencies relative to the dollar.

The iShares Currency Hedged MSCI EAFE ETF actually holds the EAFE ETF as its only holding. It also layers on currency contracts that effectively neutralize any currency changes. It reduces overall volatility and removes a potential wild card from the risk/reward profile.

The currency market changes are what drive the difference in performance between the two funds.

For example, suppose that a basket of Japanese stocks was up 8%, but the yen fell by 10% relative to the U.S. dollar. An investment in a currency-hedged Japanese stock ETF would be up 8%. An investment in the unhedged Japanese stock ETF would be down 2%.

EFA vs. HEFA: A decade of performance data

Data source: iShares.

Over the past 10 years, the currency-hedged ETF outperformed the unhedged ETF by 3 percentage points annually. It did that with roughly 10% less volatility.

In dollar terms, that means a $10,000 investment in HEFA a decade ago would have turned into roughly $32,700. In EFA, the same investment would have become $25,000. That's a rough difference of $7,700.

The general relationship here is that if the dollar is stronger, HEFA should outperform EFA. If the dollar becomes weaker, the opposite would occur. The dollar has generally done well globally over the past decade, but it's been a volatile ride at times. The risk reduction from removing the currency fluctuations has been meaningful.

Currency-hedging international stocks are a better pure play

In many cases, using a currency-hedged international stock ETF makes a lot of sense for retail investors -- not because it's outperformed the unhedged version over the past decade, but because it's a significant risk reduction.

Plus, your investment results are based solely on the performance of the underlying stocks. It's a better option for direct exposure to foreign economies. That's something that a lot of portfolios could benefit from.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.