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Hedging Currency With ETFs to Dampen Volatility

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Innovation has undoubtedly played a key role in the ETF marketplace, and in the last couple of years there has been a proliferation of funds that hedge as part of their investment strategy. Among the most popular ETF strategies have been foreign equity funds that hedge out currency exposure, but there also have been ETFs issued that hedge interest rate risk as well.

The need for interest rate hedging has not been that great as rates have generally continued to drift lower, but there has been a spotlight on currency-hedged equity funds as the U.S. dollar has gained strongly against most major currencies. ETFdb.com reported that through April 1, there are 26 such currency-hedged equity ETFs.

It bears repeating that the success of this segment—with over $40 billion in total net assets—has been helped by large moves in the currency market that have favored the U.S. dollar. Over the last one-year period (as of April 1), the U.S. dollar was up approximately 17% against the Japanese yen and in that same period, the euro had declined approximately 22% against the U.S. dollar.

The currency action has led to considerable outperformance of hedged funds over unhedged funds. In the last one-year period (as of April 1), the difference has amounted to more than 5% when investing in Japan and a 24% difference when investing broadly in Europe.

However, advisors and investors considering currency-hedged products need to understand the nature of the currency market before buying one of these ETFs. There are often large one-directional moves in currencies lasting several years that can then reverse direction for equally large moves.

During the first half of the 1980s, the U.S. Dollar Index (DXY), which compares the U.S. dollar to a basket of currencies, doubled in price, representing dollar strength. During the second half of that decade, DXY cut in half and then some, giving back all of the gain. The index then churned back and forth until 1996 when it had a four-year 50% rally; only then to realize an eight-year 40% decline into the start of the financial crisis in 2008, before again churning back and forth for several years leading to the current U.S. dollar rally.

Without making any predictions, it makes sense to expect some sort of reversal that will eventually favor other currencies over the U.S. dollar. Should that occur, the performance advantage would of course swing back to unhedged strategies.

It’s imperative to remember that choosing currency-hedged or unhedged amounts as a directional bet on currencies can have serious implications. The wrong call can result in opportunity costs of hundreds or even thousands of basis points in your clients’ portfolios.

A more suitable use for currency-hedged ETFs might be as a diversification tool. Instead of one or the other, allocating to both always means having the outperforming exposure. This of course also means having the underperforming exposure, but blending the two approaches together should result in reduced portfolio volatility.

As we have witnessed in the market, ETF sponsors continue to lead the development efforts of new and innovative investment strategies. Expect many forms of hedging to increase. There has been a rise in ETFs focused on hedging interest rate risks with probably many more products to come. A big part of the goal of any hedging strategy is to reduce volatility and improve risk-adjusted returns, but certainly not all of them will be able to accomplish that feat. For advisors, it will be important to get constant education and leverage the daily transparency found in ETFs to facilitate your due diligence.

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