100% Currency Hedging A Loser's Game

Adam Patti is CEO and founder of IndexIQ, issuer of several international-focused ETFs with a unique currency-hedging twist. ETF.com sat down with Patti to get his take on the latest developments in Japan and how investors should invest in international markets in an environment of extremely volatile currency moves.

ETF.com: What are your thoughts on the Bank of Japan's move to cut interest rates into negative territory?

Adam Patti: Japan is in an interesting situation right now. The country's economy seemed to be recovering from this stagnation it’s been experiencing over the last decade or two.

But the problem is China. Japan's trade with China has increased manyfold over the last several years; and now we're seeing China's economy having issues. We don't really know to what extent the issues actually are in China because there are questions about the quality of its data and what it’s disclosing.

That certainly has a direct impact on Japan in terms of their trade, but even more important is the overall perception of the Asian region. The thought is, if China is getting soft, how is that going to impact the entire Asian region and the broader emerging markets?

Japan is trying to take steps to jump-start its economy in the face of these head winds.

It cut its rates to negative, but it has this interesting three-tiered rate structure, where the rates it actually cut below zero are really only tied to a small portion of overall bank assets.

It was really more of a headline move, but I've been shocked to see the response in currencies and equities.

ETF.com: Is it surprising to you that we're seeing so many sovereign bonds―not only in Japan, but elsewhere―trading at negative yields? I've read that there is something like $6 trillion or $7 trillion worth of sovereign bonds around the world trading at negative yields.

Patti: It wants to disincentivize people from buying bonds and to get them into equities. I believe this is unprecedented―at least in my lifetime.

It scares me. Where does this lead us? Once the central banks around the world get into negative territory, don't have anything left to do to help the economy.

ETF.com: Presumably the Bank of Japan wants to weaken the yen, but it seems to be strengthening. What's going on there?

Patti: We saw the yen weaken right after the rate cut. But then two or three days later, we saw some strengthening. The manipulation of currencies is very difficult in these times, where the central banks around the world have diverging policies and goals.

I don't have the faintest idea where currencies are going to go. I wish I could understand it. And if I could, I'd probably be running a hedge fund making billions of dollars a year.

People do have strong opinions on strengthening or weakening. But the problem is, even if you get it right, making that call and investing in that call are two different things, because it's a timing issue.

Even if you have the bull case correct in the dollar versus yen, your entry point will dictate your turns. And even within a secular bull market, in the dollar versus the yen, for instance, there are going to be severe drawdowns within those periods. If you time it wrong, you may as well not have made the trade, because you're going to end up losing money.

In my view, betting on currencies and betting 100% on hedged or un-hedged is a loser's game. It's proven out over time.

ETF.com: That's presumably why you made the 50% currency-hedged ETFs. But is that the way to go? Some would argue that if you're not going to make a call on currencies to just go with the vanilla un-hedged exposure.

Patti: Five years ago, most advisors didn't even think about the currency exposure. Now it's top of mind because of all the central bank maneuvering. This maneuvering is making the currency trade far more volatile.

By going with un-hedged exposure, you're betting on a weak dollar. We've seen the dollar strengthening for a good two years now. I don't know that will change in the near term, but we just don't know when that direction is going to change.

If you look at the research, the best way to invest internationally is hedging half your currency exposure. The reason for that is because it takes the market timing element out. You don't have to bet on a weak dollar or strong dollar. You've got your half hedge in there; it's currency-neutral.

The reality is that if you want to buy un-hedged or hedged and hold it for 20 years, you'll probably be fine. But nobody holds their securities for 20 years. The average holding period in an ETF is 18 months. In that 18 months, if you make the wrong call, you're going to decimate your returns.

The currency-neutral position is the ideal core holding. If you really have a strong view on a currency, then you can overweight using the fully hedged or the un-hedged ETFs around it.

ETF.com: On a fee basis, it looks like the 50% hedged ETFs are pretty much right in line with the other un-hedged and hedged ETFs.
Patti: Exactly. We have a 0.35% expense ratio for the IQ 50 Percent Hedged FTSE International ETF (HFXI) and a 0.45% expense ratio for both the IQ 50 Percent Hedged FTSE Japan ETF (HFXJ) and the IQ 50 Percent Hedged FTSE Europe ETF (HFXE).

We simply priced our ETF to be competitive with a blended average of 100% hedged and 100% un-hedged. This way it takes the fee issue right out of the equation.

Contact Sumit Roy at [email protected].