3 Advisor Views On Currency Hedging

To currency hedge or not? We ask three financial advisors.

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Reviewed by: Cinthia Murphy
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Edited by: Cinthia Murphy

[This article originally appeared in our June 2016 issue of ETF Report]

Allan Roth

Founder & Principal

Wealth Logic

Colorado Springs, CO

Assets Under Advisement: $1B

ETFs: 20%

I’m a big advocate of holding low-cost broad international stock funds in a portfolio. Clients often disagree with my position, though where they disagree has been inconsistent, as I’ll explain.

I’ve long recommended that international stocks should comprise about a third of one’s equity portfolio. Going back to late 2007, when international stocks had tripled in the preceding five years while domestic only doubled, clients questioned why I was only allocating a third—“Isn’t the growth coming from overseas?” Now that international stocks have badly lagged the U.S., the question is, “Why so much, given all the troubles overseas?”

This raises two points. First, the performance differentials between U.S. and international stocks can be significant. While Vanguard founder Jack Bogle is right that U.S. companies have a huge proportion of their business overseas, the fact that performance can vary by so much is evidence that one does not get enough international diversification by owning a total U.S. stock index fund. The second point is merely observing that performance chasing is alive and well.

Whether or not international stocks outperform U.S. stocks next year, diversification is important. You wouldn’t only buy stocks based in your home state, and the same logic goes for international. I’d buy an interstellar ETF to diversify if it existed.

Use Unhedged International Stock ETFs

Given that much of the volatility and underperformance over the past three years is due to the strong U.S. dollar, money has poured into international stock ETFs that hedge against the dollar. I examined currency-hedged ETFs and, though not horrible, I passed.

Why? Because they have added costs and less tax efficiency. Clearly, in return for higher expenses and taxes, they reduce volatility, yet that may not be a good thing. The long-run return from foreign-exchange hedging before costs arguably is zero, so a disciplined portfolio that rebalances can actually benefit from that greater volatility.

Finally, I suspect many investors will use these hedged international stock funds out of a belief that they know how the dollar will do against currencies like the euro. In early December of last year, I was on a panel examining hedged international ETFs. I was the outlier (story of my life), disagreeing with the logic that the dollar was certain to continue to surge against the euro with negative interest rates. The euro gained more than 5% since that date.

Not to oversimplify as these are complex subjects, but I say yes to international stock ETFs, such as the Vanguard Total International Stock ETF (VXUS | A-97) and the iShares Core MSCI Total International Stock ETF (IXUS | A-97), and no to currency hedging those stock

Rob Lutts

President & CIO

Cabot Wealth Management

Salem, Massachusetts

AUM: $600M

ETFs: 20%

Currency hedging may have been a smart thing to do a few years back. If you look at emerging market currencies a few years ago, I'm not sure anybody knew the extent of the weakness in the Brazilian real, or the Russian ruble or even the Indian rupee. They were really decimated in ways most people didn’t expect. And as a result, I don’t think most investors were hedged properly for it.

Since then, the ETF industry has come out with products to hedge that currency exposure, which is great, except you probably don’t need it today.

The most difficult forecasting job of any investment professional is to properly forecast currencies. I don’t think you should try it. You should just make good investments in asset classes you understand and believe in.

Equities is one of those asset classes. Real estate. Gold, at times, is appropriate. You should have the currency exposure in the international equity allocation you believe in, and not try to forecast currency trends. I follow a technical model to make these decisions, and I’m a firm believer that when it comes to currency hedging, the average investor should not try to do it.

Ben Lavine

Chief Investment Officer

3D Asset Management

East Hartford, CT

AUM: $768M

ETFs: 85%

I believe in currency hedging, but only as an insurance policy against the underlying exposure. Currencies are very difficult to time, but you can’t divorce the currency view from the asset class view.

That’s why we generally don’t separate the asset class exposure from the currency exposure. But we sometimes hedge our asset class views through the adoption of a currency-hedged ETF—the cost of that is essentially the insurance premium you pay in case our broad asset class views turn out to be incorrect due to monetary- and macro-regime policies. Otherwise, we don’t normally approach currency as a tactical, alpha-seeking trade.

Currently, we’re invested in currency-hedged ETFs as a way to hedge some of our emerging market exposure, and we’ve used them in the past as a way to hedge our European equity exposure from a falling euro. The key thing to keep in mind is the cost-of-carry. Think of this as the insurance premium on top of the incremental management cost to put on the hedges.

Now, when it comes to picking a currency-hedged ETF, we tend to eschew dynamic-type ETFs because we prefer static hedges. As strategists, we want to know what we’re buying, and we want to be able to get targeted exposures.

If we have a particular view on currencies, we want to be able to implement it with a static hedge. I understand the rationale for dynamic hedges because of how currencies behave—they tend to follow trends. But that’s just not something we want to employ in our strategies.

Cinthia Murphy is head of digital experience, advocating for the user in all that etf.com does. She previously served as managing editor and writer for etf.com, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.