3 Lower-Risk Foreign-Stock Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How can investors maintain global exposure while also keeping a lid on risk? Joining me to share some strategies for doing that is Morningstar analyst Dan Sotiroff.

Dan, thank you so much for being here.

Daniel Sotiroff: Hey, Christine.

Benz: Dan, let's talk about foreign stock investing, because even though the risks aren't notably higher than investing in U.S. stocks, there are some things that can add to volatility.

Sotiroff: Sure.

Benz: Let's talk about some ways to maintain globally diversified equity portfolios, but take the edge off a little bit. One you say is just a very basic strategy, which is--

Sotiroff: --Very trivial, very simple, anybody can do this, and lots of fund managers provide the means to do, is just get rid of emerging markets. Very volatile markets in general. They don't have the mature legal systems that the U.S. or a lot of Europe and Japan have. They have unstable governments. All these things sort of add up. This is just par for the course. This is what these stocks kind of look like. They're going to trade; they're going to be very volatile. Just avoid them in general.

Benz: You may though leave some return potential on the cutting-room floor. So, it's a trade-off. It's not--

Sotiroff: And the other thing I always point out to people is, these are 10% of the global market cap. Yeah, you're missing out on some opportunity there maybe. But if you're looking at sort of a global market-capitalization portfolio that you're putting together yourself, you're not missing out on a huge amount. So, yeah, they could add a little bit to your return, but maybe it's okay to give that up just to be on a little bit of a safe side.

Benz: One fund you like in that space is Vanguard FTSE Developed Markets. This is an index fund or an ETF depending on what you choose.

Sotiroff: Yeah, it's an index fund. You have the mutual fund option of the ETF share class that Vanguard offers through that sort of dual share-class structure that they have. One of the broadest, most diversified funds in the category, excellent management overall, super low fees, very tax-efficient. You really can't go wrong with it no matter which way you look at it.

Benz: Another idea is to take a look at a product that actively hedges its foreign currency risk, because--you tell me, but I think one of the major sources of volatility for foreign stock funds does tend to be those currency fluctuations.

Sotiroff: Excess volatility, we should say. Because it does add an extra layer of risk, volatility, whatever you want to call it there. An easy way to do that, it's a very mechanical process, is you have managers that essentially try to replicate the index and they will use some forward contracts to essentially lock in their forward interest--or excuse me--exchange rate and hedge out the impact of currency fluctuations. So, it's a very standard process, nothing really magical there.

The one caveat with these strategies is they do tend to charge more for the hedging feature. So, you're going to see the expense ratios be a little higher. They're still cheap within the category. They're still much cheaper than a lot of the actively managed funds out there. So, still pretty good bet from a fee perspective.

The other thing I would point out is, because they're using forward contracts to hedge out the foreign-exchange risk, it's a less tax-efficient vehicle. So, that's one thing to keep in mind with these things is, they do tend to throw off capital gain distributions, and there is some tax complexity associated with that. But all in all, they're very solid strategies, and they're very effective at what they do.

Benz: And they've gotten cheaper and therefore more attractive.

Sotiroff: And they've gotten cheaper, yeah, exactly.

Benz: One you like there, and there are a few that we like, but iShares Currency Hedged MSCI ETF, ticker HEFA.

Sotiroff: Correct. Yeah. That one goes after the EAFE Index, so foreign developed market stocks, Europe, Japan, Australia, the Far East. So, pretty standard index. Again, like I said, very standard process for hedging out currency, and it's very well-executed. So, it's a pretty solid choice.

Benz: The last strategy to consider if you are trying to lower the risk of your foreign stock portfolio would be to consider some sort of a low-volatility product. Let's talk about what these are. There are lots of ETFs that do so called low-vol strategies. What is that?

Sotiroff: So, essentially, what they're doing is they're trying to reduce the risk of owning equities in general. That's kind of a very broad mandate, like you said. There's different ways you can do that. Some of them just go after low-risk stocks. So, those types of strategies you're going to see, they tend to load up on things like utilities, consumer staples, maybe some real estate, depending on what the market is like from here, and they're just traditionally very stable industries, very stable stocks. That's one way you can do it.

Some strategies go a step further and they look at the correlations across stocks and they try to sort of optimize the weightings and the stocks that they choose based on those correlations to further reduce volatility. It's a very, you know, I don't want to say straightforward process, but it's got sound fundamental basis than a lot of modern portfolio theory out there. And it's very effective at what it does.

Benz: And here, again, this is a group of funds where, because of the entrance of a lot of ETFs and index funds in this space, we've seen cost pressure on this strategy.

Sotiroff: Exactly. That's the one nice thing about them is they've become very cheap over the past couple years. You're paying maybe 15 to 20 basis points for some of these strategies, depending on the specific market that you're going after. So, completely reasonable, very cheap way to play these markets.

Benz: One thing I've been hearing just very recently is that people think that maybe that low-volatility trade is a little bit crowded. Is that something people should consider themselves…?

Sotiroff: Yeah, I've heard that too. It's hard to say. Some people think that, but the thing is, is when stocks get expensive, that's when low-volatility is really what you should be owning, because it's usually a harbinger for a drawdown in the markets, which is when these products really shine.

Benz: Right.

Sotiroff: That's when they really show up and perform very well. Along sort of with the low-risk mandate, generally, what they tend to do is they tend to do better during drawdowns. They'll decline, just not as much as the broader market, I should say.

Benz: And among the funds that you and the team like in this area, the low-volatility area is iShares Edge MSCI Min Vol EAFE ETF.

Sotiroff: So, that's one of those--again, kind of, going back to what I was saying before, what they really do in that fund is they look for stocks that have low volatility, but then they'll also sort of fold in this correlation component. So, they will look for stocks that have low correlations with each other. So, if you're looking at the individual holdings in that fund, you may see some, like, very volatile mining companies that pop up every now and then. Again, that's more of a play on the correlations. The objective here is reducing the volatility of the overall portfolio.

The other advantage that fund has is it really maintains diversification very well. So, they limit the percent of assets that can be allocated to a single stock and they also control their sector weighting. So, they're not going to be heavily biased like utilities, the consumer staples, you know, these traditionally stable sectors…

Benz: Right.

Sotiroff: So, it's a very good play from that perspective. Like we were saying before, very low cost. 20 basis points for this fund. It's a very solid option to get access to stocks, but with less risk.

Benz: Lots of food for thought here. Dan, thank you so much for being here.

Sotiroff: You're very welcome. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.