The impact of currency hedging your ETF

May 2nd, 2018 | By | Category: Equities

To hedge, or not to hedge, that is the question faced by portfolio managers with global investment mandates. While institutional investors may have the luxury of delegating this question to a dedicated fx overlay manager, for others it has the potential to cause sleepless nights.

The impact of currency hedging your ETF

Investors may now access full, partial, or dynamic currency hedging through the ETF wrapper.

One thing is for sure, the performance differences between being hedged or unhedged can be stark, as demonstrated by the returns of Euro Stoxx 50 equity ETFs over the past month where unhedged dollar-denominated investors were 2.2% worse off than those who were hedged.

The iShares Core Euro Stoxx 50 UCITS ETF (ISX5 LN), which trades in US dollars on London Stock Exchange, returned 4.0% over April 2018, while the Lyxor Euro Stoxx 50 USD Daily Hedged UCITS ETF (MSEU LN) returned 6.2% over the same period.

Currency-hedging does of course carry risks. If hedging is enacted and the foreign currency appreciates, this will lower the portfolio’s total return and may push an otherwise positive gain into the red.

Trying to time currency swings is also very difficult, to say the least. Some of the fundamental factors moving currency pairs (interest rate differentials, investment flows, and investor sentiment) are in a constant state of flux and can change quickly.

What is an investor to do? A common tactic is simply to leave the position unhedged. Behavioural finance explains why this approach is popular – investors have a tendency towards ‘regret aversion’, deciding not to act on an investment decision to avoid the regret that would occur if the decision turned out to be a bad one.

However, as shown above, returns may be being left on the table.

New York-based ETF issuers IndexIQ came up with an innovative, albeit very simple, approach to the dilemma. It launched a series of ETFs that hedge 50% of the foreign currency exposure. This compromise, although considered indecisive by some, may actually present a suitable choice for investors who do not wish to express a currency view in either direction.

Some ETF issuers have sought a more sophisticated solution by incorporating a rules-based dynamic hedge based on certain indicators. This approach is not yet available in Europe, but in the US WisdomTree launched a suite of such funds.

Its range of four dynamic currency-hedged ETFs, targeting European, Japanese, international, and international small-cap equities, determines the optimal portfolio hedge by evaluating three signals drawing upon both technical analysis and fundamental economic theory. These signals are currency momentum, currency value, and interest rate differential.

But regardless of the method chosen, many would agree that consistency in one’s approach is advisable when it comes to currency hedging to avoid the potential costs of adjusting one’s position regularly.

Theory suggests that currency hedging provides no long-term return enhancement owing to the zero-sum nature of currencies; however, studies have shown that regular hedging can reduce portfolio volatility, thereby leading to superior Sharpe ratios.

The jury may still be out on much of this, but our previous example of Euro Stoxx 50 ETFs seems to verify the notion. The iShares Core Euro Stoxx 50 UCITS ETF has shown annualised volatility of 23.6% since January 2015 while the hedged Lyxor Euro Stoxx 50 USD Daily Hedged UCITS ETF has 20.1% annualised volatility over the same period.

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