Are currency-hedged ETFs the right choice?

Jun 23rd, 2015 | By | Category: Equities

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Recent volatility in currency markets has awakened investors to the negative effect currency movements can have on asset returns, but is this a call for wider adoption of currency-hedged strategies or simply short-term noise which should be ignored by long-term investors?

Are currency-hedged ETFs the right choice?

Foreign exchange volatility has led to a surge of inflows into currency-hedged ETFs

Divergent central bank policies have driven significant currency swings in recent years. Unhedged equity returns have been eroded by moves like the Japanese yen falling 33.6% against the euro between July 2012 and December 2013 and the euro falling 22.1% against the US dollar between March 2014 and March 2015. Consequently, inflows into currency-hedged international equity ETFs have surged in 2015.

The potential losses faced by investors in international equity markets as a result of short-term moves in currency values can be substantial. According to a recent report on currency hedging from Deutsche Asset & Wealth Management (Deutsch AWM), in ten of the thirteen years between 2002 and 2014, non-domestic currency exposure contributed at least 2% to the headline returns experienced by a US dollar investor from the MSCI World index.

However, the decision to hedge should not be based on recent events or data from discrete years. In Deutsche AWM’s opinion: “For any individual investor, the choice of whether or not to hedge currencies will depend on a number of factors, including: the base currency of the investor; the investment time horizon; the nature of the hedging strategy being performed; the performance characteristics of the underlying securities and, in particular, the levels of relative risk between the asset and the currencies; the cost of the hedging strategy.”

In the short term, hedging currency fluctuations may reduce equity market volatility, but the argument for long-term investors is less compelling. Deutsche AWM’s findings point to little difference in hedged and unhedged returns over longer time horizons. For example, during the 15-year period following the introduction of the euro, the currency strengthened against the US dollar by only 2.5%, a negligible effect for the long-term investor.

According to a recent white paper from investment manager GMO, the effect hedging strategies have had on total portfolio volatility has diminished over time as markets and economies become increasingly interconnected. With companies generating a larger proportion of sales outside of domestic markets, profits are tied less to domestic currencies, offsetting some of the effect of currency moves and making hedging a more challenging task.  In fact, the report highlights that the addition of unhedged international equities can provide valuable portfolio diversification for the long-term investor.

Currency-hedged strategies attempt to mitigate currency risk and deliver equity market returns irrespective of currency movements. Recent currency moves and the historically low cost of these strategies – due in part to narrow interest rate differentials between developed economies – have increased their appeal. For investors with the appropriate time horizons, those unwilling to bare currency fluctuations, or those with a strongly held outlook for currency market direction, a hedged strategy can make perfect sense. 

There are a number of ETF options available for investors wishing to implement a currency-hedged equity strategy. UBS offers the most extensive line-up of currency-hedged ETFs, having positioned themselves as a leader in the space, with products covering a range of countries and regions. WisdomTree Europe offers dollar-hedged versions of their Japan and Europe equity ETFs, as well as a sterling-hedged German equity ETF. These ETFs are positioned to benefit from the QE programmes in Europe and Japan and target dividend-paying companies generating revenues outside their domestic markets. Similar products are available from Source such as the currency-hedged versions of their Stoxx Japan Exporters and Stoxx Eurozone Exporters ETFsLyxor provides hedged versions of their alternatively weighted JPX-Nikkei 400 ETF, which selects and weights constituents based on profitability. Additionally, Lyxor offers currency-hedged ETF share classes on the Euro Stoxx 50 Index. 

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