Currency Hedge Your ETF Or Not?

October 26, 2015

Currency-hedged ETFs are hugely popular with investors, who continue to buy into these funds looking to mitigate currency risk associated with their international stock allocations.

Some of these strategies—perhaps most notably the WisdomTree Japan Hedged Equity (DXJ | B-68) and the WisdomTree Europe Hedged Equity (HEDJ | B-50)—performed very well last year, as the dollar rose against the Japanese yen and the euro. But their returns have stalled relative to unhedged funds this year.

So we asked three ETF strategists the following question: Should investors always opt to currency-hedge, to not currency-hedge, or to use both approaches in international stock investing?

Here’s what they had to say:

Clayton Fresk, portfolio manager, Stadion Money Management (Watkinsville, Georgia):

I don’t think it’s as easy as always hedge or never hedge. The currency effect will add a layer of volatility to an international portfolio, but the flip side of this is that an unhedged portfolio can reduce the correlation to a domestic portfolio as compared to a hedged portfolio. Here’s a quick example using the MSCI USA index, MSCI EAFE Local Index and the MSCI EAFE Unhedged Index since inception in 1970:

USA EAFE Local EAFE Unhedged
Return 8.87% 7.46% 8.73%
Standard Deviation 15.29% 14.42% 17.03%
Correlation to US - 0.69 0.62

So on a long-term view, the currency effect added returns versus the local index, albeit with higher volatility. But the currency effect also lowered the correlation versus the U.S.

However, that correlation effect is also not static. Here is a shorter-term view since the end of 2001:

USA EAFE Local EAFE Unhedged
Return 5.36% 3.80% 5.35%
Standard Deviation 14.68% 14.63% 17.42%
Correlation to US 0.89 0.88

So on a shorter-term view, EAFE Local has very similar risk to the U.S., with lower return, and EAFE unhedged has a similar return, with higher risk.

A second question would be whether or not an investor is looking to hedge a developed or emerging market portfolio. While hedging a developed portfolio is relatively cheap due to low deposit rates in developed countries, the same cannot be said for emerging market countries. Here is a look at the MSCI Emerging Markets Index using an unhedged, local and hedged index:

Unhedged Local Hedged
Return 9.50% 10.11% 7.85%
Standard Deviation 22.33% 17.29% 17.41%
Ret/StDev 0.43 0.58 0.45

So while the local returns give a slight edge on return with significantly lower risk than the unhedged version, when putting the hedge into practice, one can see how expensive the EM currency hedge can be. The hedged index provides a very similar return per unit of risk as compared with the unhedged variety, therefore somewhat negating the risk reducing effect.

Lastly, with the advent of the currency-hedged ETF products, this decision does not have to be static. Ignoring transaction costs, one can move to and from these products with relative ease. So investors can be more tactical with the currency decision than in times past.

Find your next ETF

Reset All