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The Independent Adviser for Vanguard Investors
•
April 2015
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had a standard deviation of 10.6, com-
pared to a standard deviation of 15.3 for
the traditional version.
In sum, the minimum volatility
index won by losing less when markets
were falling, and, true to its name, did
so with meaningfully less volatility,
with monthly returns ranging closer to
its average than the traditional index.
While MSCI and Vanguard probably
have somewhat different approaches to
constructing minimum volatility port-
folios, the data do suggest that a mini-
mum volatility portfolio may deliver
stock-like returns with less risk over
the long run, particularly if that period
includes one or more substantial bear
markets. Not only has the minimum
volatility strategy outperformed in the
two bear markets for which we have
data, but it has kept a reasonable pace
with the traditional index in two of
the three bull markets over the last 20
years. However, I would emphasize that
the minimum volatility index did not
outperform each and every year. In fact,
there were stretches, particularly dur-
ing the bull market of the mid-to-late
1990s, when the minimum volatility
index meaningfully lagged the tradi-
tional index.
Hedging
Understanding and assessing the
currency hedging component of Global
Minimum Volatility is a bit more com-
plex. It certainly paid to hedge the dol-
lar against foreign currencies in 2014
as the dollar strengthened big-time.
For instance, the dollar gained 13.6%
against the euro in 2014 and has contin-
ued to gain on it this year. If you expect
the dollar to continue to strengthen,
then you would want to keep hedging
your currency risk. But the bigger ques-
tion is what to do about the long run.
(See the box on page 15 for the basics
of currency hedging.)
The short story is that hedging cur-
rencies on a foreign stock portfolio has
reduced returns while slightly dampen-
ing risk. The chart to the right shows
the relative returns of the MSCI EAFE
index (a broad index of foreign devel-
oped stocks) versus the same index
with the foreign currencies of its con-
stituent stocks hedged back to the U.S.
dollar, since 1969. When the line is
rising, the traditional EAFE index is
outperforming its hedged sibling.
Over this nearly 45-year period, the
EAFE index compounded at a 9.1%
annual rate, while the hedged EAFE
index gained at a 7.8% rate. This 1.3%
annual difference really adds up over
time, as the EAFE index’s cumula-
tive return of 5,082% far outpaces the
2,870% total return for the hedged
index. As with the minimum volatil-
ity index’s strategy, hedging also had
periods of outperformance. As the dol-
lar strengthened in the early 1980s and
again in the late 1990s through the early
2000s, the hedged index outperformed
the traditional EAFE index. The ques-
tion is just how far along into one of
those cycles we are right now.
As I said, risk was only marginally
lower for the hedged index. Comparing
maximum cumulative losses (MCLs),
my preferred measure of risk, the
hedged index’s worst decline was
a drop of -51.2%, while the EAFE
index’s largest drawdown was -56.7%.
Looking at volatility, the 14.4 standard
deviation of the hedged index was a
touch below the 17.1 standard deviation
of the EAFE index.
In choosing to hedge the curren-
cy risk, Vanguard is emphasizing risk
control, rather than going for the best
return, and so far that’s paid off. But
when you come right down to it, a low-
volatility portfolio construction process
has a much more meaningful impact
on reducing risk than hedging curren-
cies does. Remember, the minimum
volatility ACWI index had an MCL of
-38.6% versus the traditional index’s
-54.6% MCL—that is a meaningful
difference. Most investors aren’t going
to be able tell the difference between
the hedged EAFE index’s -51.2% MCL
and the unhedged EAFE index’s -56.7%
decline. In this case, the cost of hedging
arguably outweighs the benefits.
By the way, this isn’t the only fund
where Vanguard uses currency hedging
techniques;
Total International Bond
also features the strategy. The argument
for hedging is stronger for the bond
fund, where historically the slight drag
on returns has been matched with sig-
nificantly reduced risks—both in terms
of volatility and drawdown. (For a
deeper review of currency hedging and
the Total International Bond fund, see
the story “Seeking Income Overseas”
in the June 2013 newsletter.)
This question of how much cur-
rency risk to expose investors to is front
and center as Vanguard continues to
increase the allocation to foreign stocks
and bonds in the
Target Retirement
and
STAR
LifeStrategy
funds-of-funds.
As a reminder, Vanguard is increasing
the foreign stock allocation in these
portfolios to 40% of the overall stock
allocation—not far from the near 50/50
split of Total World Stock Index. Total
International Bond will be 30% of the
bond allocation, but the currency risk
there is hedged, unlike in the stock por-
tion. In explaining the increases to its
foreign exposure, Vanguard pointed to
moving closer to the worldwide market
cap and reducing country-specific risk.
Additionally, Vanguard said that the
increase is facilitated by falling costs
of investing overseas. What is missing
from the discussion is the increased
currency risk the changes bring.
Vanguard has consistently said that
investors should hedge currency risk
related to owning foreign bonds. I
can swallow that, but by Vanguard’s
own admission in a September 2014
research report,
To hedge or not to
hedge? Evaluating currency exposure
in global equity portfolios
, “the case
for hedging [currency in] an equity
The Cost of Hedging
Currency Risk
2/70
2/75
2/80
2/85
2/90
2/95
2/00
2/05
2/10
2/15
0.75
1.00
1.25
1.50
1.75
2.00
2.25 Rising line = Unhedged EAFE
outperforming Hedged EAFE
>
SEE
CONVENTION
PAGE 14