Few investors buying international stock ETFs fully understand what makes up the return. For example, investors betting on (or against) European equity markets might decide to trade the EAFE Index ETF (EFA). When fears over Greece erupted earlier this year, the popular ETF went down heavily before recouping its losses.
A trade in the EFA ETF, however, is also an inherent trade in the euro. Because the ETF gives exposure to European stocks which are naturally denominated in euros, you are essentially converting your U.S. Dollars into the international currency. Notice the similarity in price movement specifically in April-May of the EFA ETF when compared against the Euro ETF (FXE).
European equity markets on average actually did not drop as badly as the EFA ETF would suggest. It was the euro which caused the big decline. Want an even clearer view? Take a look at the price ratio of the euro divided by the EFA ETF (currency divided by equity):
The fact that the price ratio range has been in a band of roughly 2.6 to 2.4 all years indicates that nearly all return from the equity ETF is because of its unhedged currency exposure. This is not the only example. Many of the other popular ETFs which give investors exposure to Austalia (EWA), Brazil (EWZ), India (PIN), South Africa (EZA), etc. have the same respective currency impact.
The main point I want to emphasize here is that unless the ETF specifically hedges currency movements, whenever you buy a non-U.S. equity fund, you are also going long the underlying currency and short your own. This can be perfectly fine, unless you believe that the U.S. dollar begins to appreciate while at the same time you continue to invest in international equity ETFs. Doing so could result in very different returns than you might think.
Disclosure: The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.