Currency Hedge Your ETF Or Not?

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:

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:

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:

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.

Tyler Mordy, president and CIO, Forstrong Global (Toronto):

Currency-hedged ETFs have introduced another evolution in the portfolio management process. We are big fans.

However, the integration of active currency management in investor portfolios has been painfully slow. One primary reason is simply a knowledge gap. While most investors understand the role that equities, bonds and even commodities play in a portfolio, currencies remain opaque.

Therefore, most investors default to the academic view that currency changes “wash out” over time, so one should not try to actively manage them. That’s true—currencies do mean-revert over very, very long periods. But those with the responsibility of managing money don’t have the luxury of these types of 20-year or more time horizons.

And now, in a globalized and crisis-prone world, you simply cannot ignore currencies. Capital has a way of seeking out the safe havens and penalizing others who are not safeguarding their national currencies. Ultimately, currency risk is unavoidable—even currency hedging never completely eliminates risk; it merely changes the nature of risks.

We are now living in a progressively synchronized and interconnected financial system. The recent global financial crisis has reminded investors that correlations among different asset classes are not always stable.

During periods of market shocks, most asset class performance is much more highly correlated to equities than expected. Conversely, currencies have a very stable, low correlation. During the period 2007-2009, every asset class correlation increased significantly relative to U.S. and global equities. The one exception was currency returns.

So the case for active currency management is strong based on the following:

• Currencies can become wildly over- and undervalued—similar to stocks and other assets
• Currencies offer a source of noncorrelated portfolio returns
• Currencies diversify portfolio risk factors
• Currencies can act as a form of insurance against extreme events

How, then, to actively manage currencies?

The key is understanding which factors drive currency returns and integrating a repeatable process. Our research has shown that two factors are most important: relative valuation measures based on classical currency theory, such as relative trends in inflation, interest rate, credit, etc., and investor sentiment. Just like other asset classes, currencies can become “overloved” and “underloved.”

Dan Egan, director of behavioral finance and investments, Betterment (New York):

First, dynamic hedging is simply currency speculation, not investing. Secondly, do not bear currency risk, so do hedge or dollar-denominate in international bonds.

And finally, don't currency-hedge your stocks. The reduction in volatility isn't worth the cost.

Contact Cinthia Murphy at [email protected].