[The following "ETF Issuer Perspective" is sponsored by iShares.]
While the United States' strengthening economy has generally been positive for Americans investing at home, it's been a mixed blessing for those trying to diversify their portfolios with international stocks. They've been finding that, in many cases, the stronger dollar eats away at their returns in many developed and emerging markets when the performance is translated from the local to U.S. currency. This recent trend has a growing number of investors turning to currency-hedged exchange-traded funds (ETFs) to help manage the risk.
In the last two years, investment in currency-hedged ETFs by investors around the world grew to $59 billion as the number of funds available globally doubled to 194. These products really began grabbing significant headlines—and flows—at the end of 2014 on the back of the surging U.S. dollar. The momentum continued into 2015, with currency-hedged ETFs logging more than $12 billion in the first two months.
The dollar seems likely to continue strengthening against several other currencies due to a combination of U.S. economic growth, diverging monetary policy in other countries, surging domestic oil production and the prospect of rising U.S. interest rates. A typical dollar rally lasts roughly six to seven years, so we may just be getting started.
A currency-hedged ETF can be useful to help you minimize the effects of currency volatility. However, it may not always be the best solution. It depends on where you invest, and for how long.
How A Strong Dollar Affects Returns
You may have noticed in the last year that although the market you invested in did well, you still lost money. Why was that?
Because if you are invested in international stocks, some portion of your portfolio return will be the result of the foreign currency return.
Think of it as an equation:
Total Investor Return = Equity Return + Currency Return
The DXY, an index that measures the value of the dollar relative to a basket of foreign currencies, rallied more than 19 percent in 2014. This was its second-strongest annual return in the last 25 years, with nearly half of the total gain coming in the fourth quarter.
The dollar's strength as of late is largely attributable to the divergence between the U.S. and foreign economies. The U.S. has emerged as one of the few bright spots globally, having taken significant steps to repair its financial health following the financial crisis. Other developed nations, however, are still struggling and taking additional measures to stimulate growth.
While monetary policy in another country can help drive higher equity returns for its companies, it may also weaken the local currency, which means your total international investment return may diminish when it is converted back to the dollar.
This divergence has resulted in a meaningful difference in returns between hedged and unhedged investments in several regions. Developed markets (EAFE), emerging markets, Europe, Germany and Japan all experienced positive returns in their respective local currencies in 2014, however, registered losses when translated back into dollars, as Figure 1 shows.
Figure 1. Relative Performance Of Hedged And Unhedged Major MSCI Indexes In 2014
What Is Currency Hedging?
Simply, currency hedging seeks to protect against changes in currency exchange rates.
A currency hedge aims to minimize the currency return component, leaving you closer to the local stock return. This differs from unhedged international investments where the local stock performance is converted back into U.S. dollars, capturing both the stock and currency returns.
Currency protection involves either exchanging foreign currency for U.S. dollars or entering into a short-term financial contract that helps to neutralize the exchange rate. An investor who hedges can be expected to suffer less from depreciation in the value of the local currency relative to the dollar during the term of the hedge because the depreciation will be potentially offset by gains on the dollar hedge. However, the investor conversely will not profit from any appreciation of the local currency relative to the dollar.