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 Deborah Frame, vice president of investments at Toronto-based Cougar Global Investments.
Amid forecasts for the dollar’s rally extending through 2015, U.S. investors are focusing on exchange-traded funds that protect them against foreign-exchange losses.
Assets invested in U.S. exchange-traded funds that hedge currency risk grew 18 percent between Sept. 30 and Nov. 20 to $21.2 billion, according to data compiled by Bloomberg. That’s the largest quarterly increase since mid-2013.
Currency-hedged ETFs are proving to add value. Consider the following two comparisons:
- While the $4 billion WisdomTree Europe Hedged Equity Fund (HEDJ | B-54) returned 3.1 percent this year, the unhedged $7.4 billion iShares MSCI EMU ETF (EZU | A-63) that also invests in European stocks lost 7.7 percent.
- In Japan, where the benchmark Nikkei 225 stock average has risen to a seven-year high even as the yen has tumbled to a seven-year low, the WisdomTree Japan Hedged Equity Fund (DXJ | B-64)—the largest currency-hedged fund at $12.6 billion—has returned 8.6 percent in 2014. That compares with a loss of 4.2 percent for the iShares MSCI Japan ETF (EWJ | B-98), a $15.6 billion ETF that’s not hedged.
While currency hedging has been widely embraced in the past few years, the extent to which currency hedging is warranted and why is primarily separated into two types of expected foreign currency behavior.
Specifically, investors need to be mindful of the differences between reserve currencies and commodity currencies.
What The Research Says
While the nuances that distinguish the two types of currencies may not appear as relevant in the post-2008, and post-global quantitative easing (QE) world, the future will bring us back to normalization of foreign exchange risk.
Hedging, or, more generally, currency exposure, affects both the return and the risk of foreign investments. From a risk perspective, we find that, for bond portfolios, full hedging is the optimal strategy in almost all cases.
But for equity investments, the risk case is more complex because co-variances of equities and currencies contribute much more to the overall foreign investment risk than in the case of bonds.
A study titled “Global Currency Hedging” by Campbell, Serfaty de Medeiros and Viceira that was published in October 2008 looked at risk management of an investor who holds a diversified portfolio of global equities or bonds and chooses long or short positions in currencies to manage the risk of the total portfolio.
Over the 30-year period from 1975-2005, they found that a risk-minimizing global equity investor with a quarterly horizon should short the Australian dollar, Canadian dollar, the yen and the British pound, but should hold long positions in the U.S. dollar, the euro and the Swiss franc.
Why The Differences?
The study observed that at one extreme, the Australian dollar and the Canadian dollar are positively correlated with local-currency returns in equity markets around the world, including their own domestic markets.
The Australian and Canadian economies, being highly commodity-dependent, have positive correlations between their currencies and world stock markets, consistent with the idea that fluctuation in world economic growth is driving equity and commodity prices in the same direction.
At the other extreme, the euro and the Swiss franc are negatively correlated with world stock returns and their own domestic stock returns.
The Japanese yen, the British pound, and the U.S. dollar are in the middle, with the yen and the pound having more similarity with the Australian and Canadian dollars, and the U.S. dollar having more similarity with the euro and the Swiss franc.
Flight To Quality
The U.S. dollar, the Swiss franc and the euro are widely used as reserve currencies by central banks, and, more generally, as stores of value by corporations and individuals around the world. Their negative correlations with equity prices are consistent with the idea that shocks to risk aversion drive down equity prices and drive up the values of the major reserve currencies as investors “flee to quality.”
This “flight to quality” drives up the dollar, euro and Swiss franc at times when the prices of risky financial assets decline. This explanation takes as given that these currencies are regarded as safe assets and therefore benefit from a flight to quality.
This is consistent with the role of the U.S. dollar and the euro as reserve currencies in the international financial system. The finding that the risk-minimizing demand for euros had increased over time leading up to 2008 suggests that the euro had partially displaced the dollar as a reserve currency.
Consistent with this story, the authors found that the correlation of the euro and Swiss franc with world equity markets had become more negative in the second half of the sample, as the euro had come to play a more important role in the international financial system.
Since the financial crisis and the subsequent recession during the 2008-2009 time period, key findings show that correlations have become increasingly negative since the introduction of QE.
Reserve currencies, particularly the U.S. dollar, have tended to strengthen against other currencies during the stock market declines. There are a series of similar observations over periods including the market crash of 1987, the Russian financial crisis of 1998 and the most recent financial crisis of 2008.
The implication of negative correlations is that holding exposures to such currencies may dampen portfolio volatility, due to the offsetting nature of the asset and currency returns.
To the extent that the U.S. dollar continues to maintain its safe-haven status and the risk-on/risk-off regime persists in the future, a non-U.S. investor investing in the U.S. would be prudent to have foreign currencies unhedged.
Canadian Dollar Example
The recent example of a Canadian investor investing in the U.S. equity market is a good case in point.
During the period spanning Sept. 30, 2008 to Oct. 31, 2008, the S&P 500 Index returned -16.79 percent in local terms, while the Canadian dollar depreciated from 1.063 to 1.216 over the same period. Canadian investors with exposure to the S&P 500 Index would have potentially realized an unhedged return of -4.85 percent, while the hedged return over this period would potentially have been -19.38 percent.
As the U.S. dollar has continued to strengthen relative to the Canadian dollar since then, investment flows have supported this point.
Most of the increase in Canada's direct investment asset position in 2013 occurred in the U.S., increasing by $28.6 billion to $317.7 billion. Aside from investment, generally stronger foreign currencies relative to the Canadian dollar supported the growth of Canadian direct investment assets abroad.
The U.S. dollar has benefited from a U.S. economy that has strengthened enough for the Federal Reserve to end its dollar-debasing bond-purchase program and to begin considering the timing of its first interest-rate increase since 2006. That contrasts with Japan and the eurozone, where officials are battling deflation with further stimulus policies amid record-low borrowing costs.
When investing among the three strong reserve currencies, currencies of countries with low interest rates tend to not appreciate as much as suggested by the parity condition.
The opposite holds for currencies of countries with high interest rates. This effect is behind the global currency carry trade where investors borrow in a low-yielding currency and lend the proceeds in a high-yielding currency.
When we eventually arrive in a post-QE world, investors in global equities whose home-base currency is a reserve currency will want to minimize their equity risk by taking short positions in commodity currencies. Those include the Australian and Canadian dollars, the yen and the British pound.
At the same time, they’d be wise to take long positions in the U.S. dollar, the euro and the Swiss franc.
Until then, watch for interest-rate differentials and safe-haven status.
At the time this article was written, Cougar Global Investments held a position in the iShares Currency Hedged MSCI Japan ETF (HEWJ | D-38) in some of its asset-allocation models.
Deborah Frame is vice president of investments and chief compliance officer at Cougar. She leads the research team there, including macroeconomic, market environment and asset class correlation research used in the firm’s qualitative and quantitative asset allocation models that focus on downside risk optimization and the use of ETFs.
Cougar Global Investments, founded by Dr. James Breech, is a Toronto-based global tactical ETF portfolio strategist that uses only ETFs in its top-down global asset allocating strategies. Breech launched Cougar in 1993 around a downside risk management system he created. Contact Cougar Global at 800-387-3779 or [email protected].