Why Currency Matters

Nizam Hamid, head of sales at WisdomTree Europe, explains why investors should still care about currency risk. This article was first published in the June issue of ETF Report UK, our quarterly magazine for financial advisers, and is sponsored by WisdomTree. To subscribe to the magazine click here.

Currency risk over the past few years has spiked to levels not seen since the heights of the financial crisis in 2008 and 2009. In the case of two key foreign exchange pairs—$/yen and euro/$—volatility has been driven by unprecedented changes to monetary policy, and an interest rate and quantitative easing environment that is substantially removed from previous norms.

Unexpected Consequences

As markets adjust to these extraordinary conditions, investors have typically been left managing the unexpected consequences of this in the form of heightened currency volatility. The stark choice facing investors has therefore been how to manage this risk when investing in overseas assets.

Whilst investors have historically considered FX returns a key component of their overall returns in emerging markets, this has typically not been the case with respect to developed markets. Therefore managing the increase in developed market FX risk, especially in the context of owning Japanese and eurozone assets, has taken on added significance. Investors with an exposure to a benchmark such as MSCI Developed World would hold 12% of their assets in euros and close to 9% in yen, whilst almost 57% of assets would be US$-based.

Investors in equity assets are generally seeking to obtain the pure equity return with a limited expectation of currency related returns either positive or negative. However, in reality, currency returns have been omnipresent in non-domestic investments, although as of early 2014, investors may have had a false sense of calm as FX volatility reached multi-year lows. This relatively benign market environment was in fact merely the precursor to a sharp uptick in realised volatility combined with dramatic directional moves in both the euro/$ and the $/yen. Realised 60 day volatility jumped from around 3.75% to more than 15% for the euro/$, levels not witnessed since the financial crisis. In the case of $/yen, volatility rose to close to 12%, partially retracing the jump in volatility to more than 16% that had occurred in the first phase of Abenomics.

In the course of slightly more than 12 months, the euro moved from close to $1.40 to $1.08 and the yen from Y100/$ to more than Y120/$. Whilst the absolute level of the exchange rates were not unheard of, the rate of change was significantly greater than expected. Investors quickly realised that the consequences of quantitative easing could both drive equity gains and offset them depending on an investor's base currency and overall exposure.

Specialist Area Moving Into Mainstream

In such a scenario, there has been a rapid understanding of the need to manage currency risk, and investors have swiftly sought out appropriate and efficient hedged ETFs. Historically, currency hedging has been a relatively specialist area that has been mainly practised by larger institutional investors, asset owners and wealth managers. It is only relatively recently that currency hedged ETFs have come to the fore as instruments of choice, allowing investors to manage currency risk.

Currency hedged ETFs have brought the benefits of managing currency risk to specific exposures to a much wider investor base than was previously possible through hedging strategies. ETFs provide an excellent tool for investors given their benefits of full transparency relating to hedging methodology, liquidity, disclosure of fund holdings and performance, all combined with a low total cost of ownership. These attributes have helped create the dramatic growth in assets in two of the world's largest currency hedged ETFs—the WisdomTree Japan Hedged Equity ETF (DXJ), offering exposure to Japanese export oriented equities; and the WisdomTree Europe Hedged Equity ETF (HEDJ), which is focused on eurozone equities, also with an export tilt.

The principal reason for the success of these ETFs has been their ease of use from a portfolio perspective, allowing investors to manage currency risk in an uncomplicated way. The costs to hedge exposures in the key currencies of the euro and the yen are mainly determined by the interest rate differential between the currencies. The nature of the similar interest rate and monetary policies pursued by the Federal Reserve, Bank of Japan and European Central Bank means that the cost of hedging currency with one-month forwards is currently relatively low. At the end of March 2015 the annualised interest rate differential relative to the US$ for hedging yen exposures was approximately -0.3%, whilst for the euro it was around -0.2%. A negative cost to hedge into US$ represents a positive return. The associated transaction costs related to maintaining the hedged position on a consistent basis are relatively low over the course of a year.

The availability of easy-to-access hedged ETFs completely changes the dynamics of the investment proposition as to whether hedging currency exposure is a meaningful and cost effective strategy. Investors typically want to manage unexpected sources of risk present in their investment holdings, and although some may view currency returns as a zero-sum game over the longer term, it is clear that short- to medium-term trends can have a substantial impact on returns.

Adding Value

Strategically, currency hedging adds value to the investment process. This proposition was formulated by Andre F. Perold and Evan C. Shulman in their 1988 paper, "The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards," published in the Financial Analysts Journal. In this paper they noted that, "On average, currency hedging gives you substantial risk reduction at no loss of expected return.

Our prescription does not say the prescient investor should not selectively lift a hedge, just that hedging should be the policy, and lifting the hedge an active investment decision."

As investors ponder how much active risk they wish to assume based on currency exposure, it is likely that there will continue to be a strong focus on currency hedged ETFs. More importantly, there is every possibility that these become more closely aligned to being strategic holdings rather than tactical investments based on recent short term currency trends.

Is FX An Asset Class?

Another factor favouring the use of currency hedged products is that few investors view FX as an independent asset class. Therefore the risk they are exposed to can best be described as an unintended consequence of the asset class investment decision. In other cases, investors manage these types of risk at a broader tactical asset allocation level with an overlay strategy that changes dynamically as macroeconomic expectations vary.

Hedged ETFs are likely to be a permanent and growing feature of the investment landscape based on the fact that they add value and simplicity to the allocation process and management of risk. The world's largest currency hedged ETFs, both from WisdomTree—DXJ (Japan) and HEDJ (eurozone)—will be available to European investors for the first time in a UCITS format in the next few months. This is particularly relevant to those investors managing US$ assets and portfolios, providing them with a tax efficient UCITS vehicle with intraday liquidity available via multiple European listings on the LSE, Deutsche Borse, Borsa Italiana and Swiss Exchange. Bringing these strategic ETFs to Europe will help broaden the accessibility of currency hedging, and benefit clients accordingly.