Currency war has become a global buzzword phrase. It describes a situation where countries purposely devalue their currency to gain a competitive economic advantage. This tactic causes all kinds of chaos, including retaliatory action by other countries that can hurt international trade. It can also damage investment returns.

Let’s examine how financial advisors can defend client portfolios against the disruptive forces of currency warfare.

Dissecting Returns

Foreign investments in stocks and bonds aren’t just affected by local economic activity, interest rates or earnings—but by currency values too. While this doesn’t diminish the importance of securities diversification, gyrations in foreign exchange rates are an added dimension of financial risk. How can financial advisors mitigate these risks in client portfolios?

The first step is to recognize that performance returns on international investments—whether they be stocks or bonds—are significantly impacted by the direction of the currencies those assets are denominated in. (Our case study of Japan below will illustrate this point.) This means that advisors should consider currency hedged positions when warranted.

Hedging tools like currency futures, forwards and options are available, but their complexity makes it difficult to implement a cost-effective hedging solution that clients can also understand. On the other hand, currency-hedged ETFs, because of their reasonable fees and relative simplicity, offer a viable hedging alternative.

Here’s a quick snapshot of the top currency hedged equity ETF providers:

  • Deutsche Bank offers 11 X-trackers MSCI international currency hedged equity ETFs that charge annual expense ratios between 0.35% up to 0.65%.

  • BlackRock’s iShares offers 5 currency hedged ETFs that charge expenses 0.39% up to 0.70%.

  • WisdomTree offers 12 currency hedged ETFs that charge annual expenses between 0.43% up to 0.58%. The company also offers a Japan small cap fund (DXJS) along with Japanese sector funds like financials (DXJF) and real estate (DXJR).

Currency Catalysts

A major driver behind the ups and downs of currency prices is the monetary activity by global central banks. Advisors should ask: What is the monetary cycle of the international market where I’m investing clients’ money and how will it affect returns?

“There is no bigger global macro play right now than long U.S. dollar versus other currencies in particular the euro,” said Frank Stanley, a CFP and president of Global Wealth Analytics in Encinitas, California. “The U.S. is at a stimulus unwinding point and the ECB and other countries are midway through their stimulus measures. These moves can last six months to two years so they are shorter term in nature.”

If a central bank is in a loosening cycle, a weaker currency in that respective country or region is likely. On the other hand, a tightening phase is more likely to lead to a stronger currency and less need for hedging. “Ignoring these factors would have a major impact on foreign equity positions,” notes Stanley.

Case Study: Japan

The historical performance of currency markets shows there’s a very close correlation between central bank activity and the value of currencies.

Shortly after Japanese Prime Minister Shinzo Abe took over in December 2012, he implemented massive economic programs (Abenomics) and reforms to help lift Japan out of its longstanding deflationary funk. Japanese stocks responded to Abenomics by surging in 2013. However, the Japanese yen didn’t fare so well and slid significantly in value relative to the U.S. dollar.

The $15.66 billion iShares MSCI Japan ETF (EWJ) climbed 25.96% in 2013 and the fund does not hedge currency exposure. Although Japanese stocks performed strongly during this period, the yen’s swift slide significantly weakened unhedged performance returns. By comparison, the Deutsche X-trackers MSCI Japan Hedged Equity (DBJP) surged 50.15% in 2013.

Like other ETFs that attempt to hedge currency exposure of non-U.S. dollar denominated securities, DBJP invests a portion of its assets in foreign currency forward contracts and other derivatives to accomplish its mission.

“Clients are beginning to be aware of currency and the currency effect. It’s a risk they now have the ability to control with currency hedged ETFs,” said Dodd Kittsley, head of ETF national accounts and strategy at Deutsche Asset and Wealth Management.

Stock Effects

As the recent subpar performance of the Japanese yen illustrates, currency moves can have a meaningful impact on international equity returns. The challenge: When the U.S. dollar is rising, gains on non-U.S.-dollar-denominated securities can be diminished when converted back into U.S. dollars. Investors wanting exposure to underlying local markets while muting currency fluctuations can help neutralize this risk with a currency-hedged investment.

Current trends point toward an outlook for further dollar strength and weaker currencies abroad. The Bank of Japan, European Central Bank and People’s Bank of China are in easing mode and still a few years behind the curve of the U.S. Federal Reserve’s stimulus programs. That could make these particular regions attractive targets for currency hedging.

Hedging Choices

Once you’ve identified an international securities market where you want to invest, the next step is to determine whether currency hedging those positions is appropriate.

For example, an advisor who wants to obtain exposure to European stocks but believes the euro will depreciate relative to the U.S. dollar may want to consider hedged solutions like the Deutsche X-Tracker MSCI Europe Hedged Equity ETF (DBEU), the iShares Currency Hedged MSCI EMU (HEZU) or the WisdomTree Europe Hedged Equity ETF (HEDJ).

The abovementioned ETFs can be used as stand-alone hedging solutions or in conjunction with existing unhedged equity ETFs to combat the risks of falling currency prices.

Currency moves are unpredictable and fluctuations can have an adverse impact on portfolio returns. Although currency risk is a threat some investors are just starting to learn about, the tools to attack the problem exist.

Using currency hedged ETFs can be a smart cost effective solution that helps you to control foreign exchange rate risk. Don’t let global currency wars take a bite from your clients’ future performance returns.