Currency hedging is one of the key emerging trends in exchange-traded funds, one that has seen an explosion over the past year and can help provide clients with a new, flexible option to manage risk in their portfolio. While a small number of currency-hedged ETFs have been around for some time, the number of currency-hedged ETFs doubled in 2014. Their increasing popularity and importance is partly due to the economic environment and partly to the ongoing expansion of ETFs into new parts of the investment spectrum. To really maximize this sort of ETF, it is important to review the basics of currency hedging.
Currency hedging is designed to allow investors to gain international exposure without being affected by moves in exchange rates. When investing in a foreign stock, whose price is measured in a different currency, the U.S. investor can make or lose money as a result of changes in the price of the stock or the exchange rate. Conceivably, a stock could be unchanged in price on the local exchange and the U.S. investor could still lose money because the foreign currency drops against the dollar. Currency hedging removes this risk by entering into a separate investment that goes up when the foreign currency falls against the dollar. The surge of ETFs created to hedge against the Japanese yen is an excellent example.
Currency hedging works by measuring the underlying currency exposure of the holdings and then entering into agreements with another party to accept the returns on one currency in exchange for the other. There are two major costs to currency hedging. First, transaction costs, which tend to be fairly low because the currency market is so vast. Second, each party has to pay the other for the interest they would have received from the home currency. In the case of major developed currencies, these costs are low because interest rates are very low in the major developed countries.
MONETARY POLICY AND CURRENCY HEDGING
The near-term interest in currency hedging is tied to the slow-growing global economy, which causes central banks to try to invigorate growth. One technique has been to cut interest rates and engage in quantitative easing, with the goal of pushing short- and long-term interest rates lower. A side effect of lower interest rates, however, is a decline in the currency. A lower yielding currency is worth less to investors and tends to increase the competitiveness of a country's exports, improving economic growth.
(More: How currency hedging saved portfolios in 2014)
Given the crisis of 2008, we are seeing multiple cases in which a central bank engages in QE, lowering rates, which pushes the currency lower. In these cases, the stock market typically reacts positively to the news. Growth is expected to be higher, exporters are more competitive with the rest of the world and any profits a company earns overseas are also worth more in the home currency, improving earnings.
For example, on Oct. 31, 2014, the Japanese central bank surprised investors with a new round of QE. The Japanese market shot up 4.40% but the yen fell sharply against the dollar and, in the end, U.S. investors who didn't hedge the currency gained 1.46%, almost 3% behind the market.
EXPANDING CHOICES
ETFs, which have “democratized” numerous asset classes such as industrial commodities, gold, bank loans and strategic beta, are a natural choice for bringing currency hedging to investors. Currency hedging is the next asset class that was once reserved for institutions and is now available to investors.
There are a number of providers offering currency-hedged ETFs. The largest currency-hedged ETF is WisdomTree's Japan Hedged Equity (DXJ) and the second is the WisdomTree Europe Hedged Equity (HEDJ). These two ETFs are the oldest in the space and they overweight export-oriented firms. Deutsche Bank tripled the size of the market when it launched four hedged X-trackers targeting the MSCI EAFE (DBEF), MSCI Emerging Markets (DBEM), MSCI Germany (DBGR), and Japan (DBJP). Both WisdomTree and Deutsche have continued to expand their offerings and iShares joined the fray early this year.
(More: Swiss franc fallout hits some liquid alt funds harder than other)
WHAT'S IT MEAN FOR CLIENT PORTFOLIOS?
Hedging currency risk has consistently tended to lower portfolio risk. Comparing the risk of the local index (effectively a zero-cost hedge index) and the index in dollar turns (the standard benchmark) shows a marked risk differential. Calculating nine years of rolling one-year weekly risk measurements yields 472 data points. In every rolling year, the hedged version has lower risk.
Currency hedging is having a breakout year. The economic environment favors it for many investors, and the number of choices available has doubled. While these intermediate-term factors are very important, don't forget the attractive long-term risk characteristics that currency hedging brings to the portfolio.
Scott Kubie is chief strategist at CLS Investments.
