With investing becoming increasingly international, the reasons to hedge currency exposure are becoming better and better.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Scott Kubie, chief investment strategist of Omaha, Neb.-based CLS Investments.
Currency-hedged ETFs are in full bloom, growing from a few idiosyncratic ETFs to a major subset of the international ETF marketplace.
In the U.S., there are currently 26 currency-hedged international ETFs available. Half of those were launched this year and only six have been around long enough to have a three-year track record. In light of the expanding lineup of currency-hedged ETFs, investors should consider how using currency-hedging might adjust their strategic and tactical allocations.
The largest currency-hedged ETF is the WisdomTree Japan Hedged Equity Fund (DXJ | B-64) and the second is the WisdomTree Europe Hedged Equity Fund (HEDJ | B-50). These two ETFs are the oldest in the space and they both overweight export-oriented firms. Deutsche Bank tripled the size of the market when it launched four hedged ETFs. They are:
- Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF)
- Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEM)
- Deutsche X-trackers MSCI Germany Hedged Equity ETF (DBGR)
- Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP)
Both WisdomTree and Deutsche have continued to expand their offerings, and iShares joined the fray early this year, a clear sign that fund sponsors are ready to meet investor demand.
Growing International Focus
The importance of currency hedging is linked to a changing investment landscape. Strategically, the investment community has been migrating toward a single equity asset class, global equities, rather than breaking up portfolios into domestic and international buckets. While most still break those categories into two groups, there is greater recognition that the line between domestic and international isn’t always clear.
The globalization of business, markets and research is contributing to an increased allocation to international stocks in the portfolio.
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).
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:
- Anytime the strategic international allocation is increased, investors should look at hedging some or all of the increase to keep risk in line.
- 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.
- If a decision is made to tactically increase the international allocation, then consider hedging some or all of the overweight position.
- 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].
Please click here for a complete list of relevant disclosures and definitions.