A Drag On Returns
My estimate for the total annual currency hedging cost for HEEM is 4.9 percent. That’s the weighted average of the portfolio country weights and prevailing interest rates, less the U.S. rate.
|Country||Weight In Portfolio||Local Interest Rate|
|weighted average interest rate||5.2%|
|less U.S. interest rate||0.25%|
|= annual FX hedge cost||4.9%|
Estmate for HEEM. Portfolio weights from EEM (issuer site 9/25/14). Interest rates from TradingEconomics.com.
Rates for "other" countries = weighted average of other 16 countries.
Does this mean HEEM is doomed to lag its unhedged sister the iShares MSCI Emerging Markets (EEM | B-97) by 4.9 percent each year? Not at all. If emerging markets take off while their currencies plunge against the dollar—a topic for another day—HEEM and DBEM will crush their unhedged peers.
The point is simply this: Hedging currency comes with a price tag that drags on returns.
For Japan equities, that cost is tiny due to the low interest rate in Japan, which is part of the appeal of blockbuster ETFs like the WisdomTree Japan Hedged Equity ETF (DXJ | B-62) and the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-71). However, the cost is much higher for a basket of emerging markets. The cost won’t show up in the expense ratio, but it will flow through to the bottom line.
We face costs to hedge out risks every day—like insurance on cars and homes. When hedging currency risks in the emerging markets, the cost isn’t as obvious as an expense ratio, but it’s just as real.
Be sure to figure it into your buy decision.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.