The Importance Of Currency-Hedged ETFs

September 12, 2014

More Risk Internationally

But this increase is not without some interesting side effects. A notable one is increased risk. International markets are riskier than domestic markets, based on global beta and standard deviation.

While investors may be open to higher international allocations, they may not want the overall risk of their portfolio to rise.

Fortunately, currency hedging provides the solution. Hedging currency risk has been a very consistent risk reducer. Comparing the risk of the local index (effectively a zero cost hedge index) and the index in dollar terms (the standard benchmark) shows a marked risk differential.

Calculating nine years of rolling one-year weekly risk measurements yields 472 measurements. In every rolling year, the hedged version has lower risk. The chart below shows that over the same 10 years of source data, the unhedged had a 30 percent higher standard deviation than the return of the local index.

To make the comparison more difficult, the beta is calculated compared to a blend of the Russell 3000. Because the currency-hedged index loses the currency diversification, the correlation between it and the U.S. market will be higher.

The higher correlation translates into some risk increase, but in only 29 of the 472 cases was the beta of the currency-hedged index higher. Most occurred around 2007, when the currency portion of international return was basically equal to the return of the equities.

Over the full 10-year period, the risk of the hedged index, minus costs, remains considerably lower. Interestingly, the monthly standard deviation and beta for the hedged index are lower than the Russell 3000 as well (see chart below).

Beta_Vs_Russell

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