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 Ellie Lan, an analyst on the investment team at Betterment, an automated investing service.
When you buy things in a foreign currency—whether that's goods and services as a traveler, or stocks and bonds as an investor—you are faced with a central issue: How far will your dollar go?
Exchange rates ebb and flow on a daily basis, which creates currency risk. For the infrequent traveler, that may be an acceptable risk, but for the investor, the currency risk could wipe out his portfolio gains.
Today, this is an increasingly visible issue for investors as the integration of global financial markets is making it easier for investors to access far-flung markets and asset classes.
Translating Returns To Dollars
When foreign investments are denominated in a currency other than U.S. dollars, the returns you make on them must be translated back to American currency. That means an international fund's performance, when reported in U.S. dollars, also includes the effect of exchange-rate movements.
Individual investors are not immune to currency movements, either. If his or her own investments are issued in a foreign currency, he or she may lose if the exchange rate moves against them, even if the investment itself has a positive return.
For example, if John is invested in Apple Inc. bonds that are denominated in the yen, and the yen depreciates against the dollar, when John converts from the depreciated yen back to the dollar, his investments may be worth less even if Apple sees great returns.
Yet a well-diversified portfolio can help avoid that risk, allowing investors to tap the upside of diversification while managing risk associated with currency fluctuations.
The Origin Of Currency Risk
Governing bodies around the world set economic agendas independently. Monetary policies, as a result, range from economic region to economic region, resulting in varying interest rates. Interest rates, in short, are the rate at which borrowers pay lenders.
Countries use interest rate targets as tools to manage their own economies. For example, central banks can reduce interest rates to encourage investment and consumption in that country—or raise rates to deter borrowing. Interest rates directly affect currency exchange rates and thus create currency risk.
While rates are being re-evaluated by countries, the good news is that rate changes do not work in lock step. For an investor who's invested in bonds of different countries, the internationally diversified bond portfolio may allow investors to lessen their overall interest rate risk.
Importantly, however, this exposure to currency risk is an uncompensated risk. Changes in exchange rates create return volatility without introducing additional expected returns. While rate changes may randomly add returns in your favor in the short term, the expectation should always be of zero return over the long term.
The Carry Trade
It is true that currency moves can be profitable if you are on the right side of them. The "carry trade" involves borrowing from low-interest rate currencies to invest in high-interest rate currencies. This strategy has demonstrated it can be profitable over some periods of time.
However, the same carry strategies exhibited large losses during the 2008 financial crisis, making the point that such strategies' "tail risk" (risk of unpredictable losses) potentially cancels out their profitability during more normal times.
How To Mitigate Currency Risk
There are two ways to mitigate currency risk:
1. Buy foreign securities issued in U.S. dollars.
A U.S. investor who wants to invest in the bonds of the Mexican government, for example, can invest in bonds that are purchased, have income issued, and have principal returned in U.S. dollars. By doing so, he or sheis never exposed to dollar-peso currency risk.
In contrast, a U.S. investor who purchases a U.S. bond issued by Apple Inc. but denominated in Japanese yen is exposed to currency volatility. So a U.S. investor investing in a U.S. company can still be exposed to currency fluctuations if the bond is denominated in another currency.
2. Hedge currency risk.
In the simplest terms, a currency hedge is insurance against a currency move in either direction, for or against you. A currency hedge technically involves two parties exchanging a set amount of one currency for another at a predetermined exchange rate and amount at a future date. When you hedge currency risk, you can remove currency risk from your investment… at a cost.
The hedge itself costs something to manage and maintain. The cost depends on the currency being hedged—liquid developed currencies are generally easier and cheaper to hedge than emerging ones. In exchange for this cost, your investment will likely have lower volatility, as the currency fluctuations are removed.
There are many ways to hedge currencies. These include forwards, swaps, futures, and options. All of these methods allow investors to lock in a set exchange rate today to eliminate potential exchange rate volatility that may arise in the future. To permanently hedge an investment, an investor must continually close contracts that have come due, and invest in new ones further into the future. This process is called "rolling" the contracts, and can have a small ongoing transaction cost.
Hedge Int'l Bonds, Not Stocks
Currency hedging, like most insurance, is not free, and so the benefits need to be balanced against the cost.
If hedging costs you more than it benefits you, you shouldn't do it. To find out, weigh the reduction in volatility against the incremental cost of buying the hedged (rather than unhedged) version of the ETF.
A Vanguard study analyzed the impact of currency hedging on foreign bonds and stocks and found that hedging is beneficial for bonds but not for stocks. This is because of the different volatility characteristics of stocks and bonds, and their correlations with currency moves. Bonds, as an asset class, are typically less volatile than both stocks and currencies.
When you take a position in unhedged foreign currency bonds, the volatility of the investment will come predominantly from the currency fluctuations, not the bonds themselves. Research has shown that the volatility of unhedged currency fluctuations often overwhelm the diversification benefits that international bonds bring to a portfolio.
In contrast, because currency risk is usually a very small proportion of volatility in foreign stocks, there is far less benefit from hedging the stock exposure. Compare the relative contribution of the currency component to the overall return and volatility in bonds and stocks.
Hedging Currency Risk Has Greater Impact On Bond Than Stocks
Whether it's stocks or bonds, currency does not contribute substantial returns. However, it has a substantial risk in terms of volatility, and all the more so when it comes to bonds. The increase in risk of not hedging bonds is significant and cannot be overlooked.
Currency Hedging Reduces Volatility
The graph above illustrates the volatility difference between international bond ETFs with currency risk versus their currency risk-free counterpart. Vanguard's Total International Bond ETF (BNDX | B-57) hedges out the currency risk through currency forwards. In contrast, the iShares International Treasury Bond ETF(IGOV| B), keeps the currency volatility intact. The daily volatility inherent to IGOV is more than twice that of BNDX.
The sharp increase in volatility because of currency fluctuations applies to emerging market ETFs, as well.
The Vanguard Emerging Market Government Bond (VWOB | C-39), eliminates currency risk by investing in dollar denominated government bonds issued by emerging markets. The iShares Emerging Markets Local Currency Bond (LEMB | C-87) likewise tracks emerging market sovereign bonds but includes currency risk by investing in bonds denominated in the local currency. The local-currency version has nearly twice the volatility of the dollar-denominated version.
Balancing Cost & Volatility Reduction
Volatility is only part of the equation. The other aspect of making the decision about hedging is the cost of hedging. The below chart illustrates the additional cost of the hedged ETF and the volatility reduction associated with using a hedged ETF.
As is seen with the Vanguard's BNDX, the ETF without the currency risk is not always the most expensive. Although BNDX eliminates the currency risk, it also charges 15bps less in terms of expense ratio cost. The reduction in currency volatility associated with stocks, on the other hand, is less drastic despite the higher cost of hedging. If you are not as familiar with the funds, see the bulleted list below.
|Asset Class||Hedged Fund Expenses Ratio||Unhedged Fund Expense Ratio||Additional Cost of Hedged ETF||Volatility Reduction|
|Developed Internationals Stocks||0.35%||0.09%||0.26%||-3.40%|
|Emerging Market Stocks||0.68%||0.15%||0.53%||-5.60|
|Developed International Bonds||0.20%||0.35%||-0.15%||-7.90%|
- iShares Currency Hedged MSCI EAFE (HEFA | D-49): tracks the performance of large and mid-cap equities in Europe, Australasia, and the Far East.
- Vanguard FTSE Developed Markets VEA |A-93): tracks the performance of the FTSE Developed ex North America Stock Index. The companies are mostly large and mid-cap companies. Canada and the U.S. are excluded. VEA is in the Betterment portfolio.
- iShares Currency Hedged MSCI Emerging Markets (HEEM | D-52): tracks the performance of large and mid-cap emerging market equities. The currency exposure is offset through currency forwards.
- Vanguard FTSE Emerging Markets (VWO | B-87): invests in large, mid, and small cap equities in emerging markets. VWO is in the Betterment portfolio.
- Vanguard Total International Bond (BNDX | B-57): tracks the performance of the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged).
- iShares International Treasury Bond (IGOV | B): tracks the performance of an index of non-U.S. developed market government bonds.
Currency Risk at Betterment
If you invest with Betterment, we have designed a bond portfolio to mitigate currency risk. We believe that the volatility attributed to currencies is not a compensated risk, and so, when affordable, it should be avoided. Whether we eliminate the risk through hedging or through a direct purchase of U.S. denominated bonds largely depends on the geography of the bond ETF. (See our interactive graphic to determine the exact geographical allocation of your portfolio.)
Geography is an important factor to take into account when determining the best way to mitigate currency risk. While it's prohibitively expensive to hedge emerging investments due to the larger number of currencies and the inefficiency of those markets, a basket of developed market currencies can be hedged efficiently.
Because of these considerations, your international developed-country bond ETFs at Betterment are hedged at the ETF level (BNDX). BNDX hedges currency fluctuations inside of the fund. In this case, the fund purchases one-month forward contracts to exchange currencies in the future at today's rates. If rates move between now and then, the investor is not exposed to those moves, because the value of the forward contract will offset the moves in currency.
In contrast, the emerging market bonds are denominated in US dollars(VWOB, iShares J.P. Morgan USD Emerging Markets Bond (EMB | B-60), PowerShares Emerging Markets Sovereign Debt (PCY | B-58) because of the cost considerations when it comes to hedging multiple emerging market countries. While the bonds are issued from developing countries, both their value and interest is defined in USD, removing concerns about currency risk.
Betterment is the largest, fastest-growing automated investing service, helping people to better manage, protect and grow their wealth through smarter technology. With more than 90,000 customers and over $2 billion in AUM, the service offers a globally diversified portfolio of ETFs designed to help provide you with the best possible expected returns for retirement planning, building wealth, and other savings goals. Betterment also helps customers get on track for a comfortable retirement with RetireGuide™, a retirement planning tool that lets people know how much they should save and if they are investing correctly.
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