Currencies Can Jeopardise Portfolio Yields

It is the largest, most liquid investment class in the world – yet investors often consider it only in passing. The asset class is currencies. The Bank for International Settlements (BIS) in Basel calculates that $5.3 trillion in currency trading takes place on a daily basis, yet for equities and bonds it comes to “only” $220 billion and $90 billion respectively. However, many international investors just look at performance returns for equities and bonds, ignoring the currency aspect, despite its potentially considerable influence on the overall yield of an investment.

Beware FX Fluctuations

The implications of taking such a narrow view were particularly evident in the first few months of 2015. In January, the Swiss National Bank decided the franc would no longer be pegged to the euro, while in March the European Central Bank announced a significant bond purchase program. These two actions meant that the Swiss franc and the euro, as well as other currencies, became more volatile compared with their historic norms.

Over a longer time frame, it is evident that currency can have a significant impact. Between December 2012 and July 2013 the Japanese yen fell 33 percent against the euro, which meant the same level of loss for euro investors in yen. Between March 2014 and March 2015 the euro fell from 1.377 against the US dollar to 1.0731, a 22 percent loss for US dollar-based holders of euro.

Looking at the performance of the MSCI World global equity index, in seven of the last 13 years, euro investors faced currency fluctuations that were greater than share price swings. The results are even more marked in the fixed income market. As an example, a euro investor in the Barclays Global Aggregate Bond Index has more exposure to currency risk than to bond prices.

The inverse is this: If you link an equity or bond investment with currency hedging then you can significantly reduce volatility and even avoid potential losses if the currency of your investment devalues against your domestic currency.

Controlling FX Within International Portfolios

Many investors choose to reduce the impact of economic developments in individual countries and regions as a whole by diversifying their investments in geographical terms.

To illustrate this point, if an investor chooses an ETF tracking the MSCI World Index, he or she will be exposed to 14 different currencies. Only 12 percent of the MSCI World Index is composed of euro-denominated equities. Consequently, from a euro investor’s point of view, 88 percent of the index portfolio is dominated by international currencies, primarily the US dollar, Japanese yen and sterling. Research shows that since 1999 euro investors have suffered a maximum one-year loss on these currencies of between 14 and 29 percent. This means that, in some circumstances, even a broadly diversified index portfolio can be significantly influenced by currency fluctuations.

However, investors should be aware of the flipside – currency hedging means that if their investment currency appreciates against the euro, for example, then they will not benefit from that uplift.

Using Currency-Hedged ETFs

Investors can choose a variety of routes to reduce their portfolio currency risk, but one of the simplest ways is to invest in an ETF that has built-in currency hedging.  Typically, these ETFs deploy a hedging instrument once a month using suitable currency derivatives to the value of the relevant fund volume.  As a result, currency fluctuation is significantly reduced for ETF investors.

Over recent years, the range of currency-hedged ETFs for euro and sterling investors has grown significantly. Relevant ETFs are now available on key equity indexes like the MSCI World, S&P 500 and MSCI Japan. In fixed income, the scope of currency-hedged ETFs includes the Barclays Aggregate Global Bond Index, as well as indexes on international sovereign bonds and inflation bonds. There are also many currency-hedged versions of commodity ETFs.

Currency-hedged ETFs are becoming more popular. Deutsche Asset & Wealth Management alone gathered more than €12 billion into its currency-hedged ETF range this year.

Investors should view currencies as a separate element of a portfolio. History proves that the currency impact for international investors can often be greater than fluctuations in the share or bond price. Investing in a currency-hedged ETF offers liquid and transparent exposure to a target market while simultaneously reducing the currency risk.

Roger Bootz is head of exchange-traded product public distribution at Deutsche Asset & Wealth Management