The Importance Of Currency-Hedged ETFs

September 12, 2014

Tactical managers gain additional benefits from including currency-hedged positions in their portfolios. Creating a partially hedged benchmark brings additional continuums and flexibility for portfolio managers to add value.

Prior to hedged ETFs, the currency decision was implemented elsewhere in the portfolio, usually by replacing bonds. A blended benchmark offers the opportunity to overweight or underweight the dollar in portfolios, where a 100 percent unhedged makes any hedged position off benchmark.

Recent years have also seen negative correlation between the currency and the stock market. Hedging offers the opportunity to take advantage of these markets without having to accept the currency losses. Having a hedged allocation in the benchmark makes these decisions easier.

Another tactical application is for investors who rotate between domestic and international. Once again, the risk differential between domestic and international equities causes the move to increase international exposure and risk at the same time.

As shown earlier, domestic and currency-hedged international have similar risk. For firms overweighting international markets, it is my suggestion that the bias be to overweight using currency-hedged strategies.

Approaches To Currency Hedging

The amount to be hedged depends on the investor and the approach. The cost of hedging is lower in markets with low interest rates, making it more effective in developed than emerging markets. While broad indexes are well covered, there are a number of countries and regions without a corresponding currency-hedged ETF.

Until more options are launched, a more granular international approach will mean less hedging. That said, I offer four instances in which the hedging discussion should be at the top of the list:

  1. Anytime the strategic international allocation is increased, investors should look at hedging some or all of the increase to keep risk in line.
  2. If an above benchmark country or regional allocation is driven by expectations of lower interest rates relative to the U.S., supporting the outperformance, then a hedged strategy may outperform.
  3. If a decision is made to tactically increase the international allocation, then consider hedging some or all of the overweight position.
  4. When the goal is to reduce risk in portfolios, without losing access to international markets.

These are the initial steps. In the near future, expect to see firms and institutions with strategic benchmarks hedging 25 to 50 percent of the international allocation.

CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Investment Strategist Scott Kubie at 402-896-7406 or at [email protected].

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