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Should Advisors Hedge Currency Risk?

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The list of financial risks to client portfolios runs the gamut of blatant hazards like geopolitics and war to more subtle threats like securities overlap and tax inefficiency. Mixed among the more subtle and frequently overlooked dangers is currency risk.

Global monetary policy has drastically changed the way investors approach international markets. Today choosing to diversify a portfolio beyond U.S. equities contains its own unique layer of analysis. Advisors must also decide whether to hedge or not hedge against foreign currency exposure.

Most mutual funds and ETFs that invest in international securities have unhedged currency exposure. In the case of U.S. based investors, they obtain securities diversification plus currency diversification. The latter feature is automatic and happens because the securities within the portfolio are denominated in local currencies. But what if those local currencies are weak or sinking in value? It can put a damper on performance.

Fortunately, there are tools to combat the dynamics of volatile currency movements. And currency hedged equity ETFs are designed to do exactly that. Let’s examine three iterations of currency hedged funds in the ETF marketplace.

100% Currency Hedged ETFs

The first iteration is the plain vanilla currency-hedged equity ETF that is hedged at all times against the basket of currencies in the ETF. For example, the Wisdom Tree Europe Hedged ETF (HEDJ) will be fully hedged against the Euro at all times, regardless of the performance of the U.S. Dollar.

Using an ETF such as HEDJ, investors get pure exposure to the companies (and countries) with no effects of currency movements. It’s never easy to predict where the U.S. dollar will move, but as in 2015, investors benefited from owning HEDJ over its un-hedged counterpart the Vanguard Europe ETF (VGK). 

50% Hedged ETFs

The second iteration are some of the newer and more innovative ETFs that partially hedge currency exposure.

Last year, IndexIQ launched a suite of ETFs that are only 50% hedged against a particular currency at all times. The logic here is that currencies over time tend to revert back to a mean and it is difficult in the short term to predict movements.

While currency valuations have historically reverted to the mean over longer periods of time, they often fluctuate dramatically over shorter horizons. This leaves tactically oriented advisors an opportunity to protect and grow capital as a result.

The IndexIQ 50% hedged products are offered in international stocks (HFXI), Europe (HFXE), and Japan (HFXJ).

Dynamic/Active Currency ETFs

Other ETFs, like the dynamic/active currency funds, automatically make the hedging decisions for you.

WisdomTree and iShares have each launched suites of products that will mechanically take the guesswork out of currency hedging. These types of ETFs examine factors such as interest rate spreads, currency momentum and currency volatility to systematically decide when to hedge or not hedge. The real beauty of these products is that they aren’t simply an on/off switch, but will add or reduce currency hedging in 25% increments based on the underlying indicators.

Historical Results

Currency-hedged ETFs have generally outperformed non-hedged currency ETFs over the past few years due to the trend of weaker global currencies relative to the U.S. dollar.

For example, the Wisdom Tree Europe Hedged ETF recorded four consecutive yearly gains since 2012 with a  cumulative gain of 57.55%. By comparison, the unhedged Vanguard Europe ETF gained just 37.72% over that same time span.

Partially hedged ETFs like the IndexIQ 50% Hedged FTSE International Stock Fund are so new that it’s too early to draw any performance conclusions.

Nevertheless, currency trends, like other investment cycles, are in constant flux. And if the trend of global currency weakness against the U.S. dollar continues, currency-hedged ETFs could be poised for further gains ahead. On the other hand, dollar weakness relative to global currencies would likely cause currency hedged ETFs to underperform.

Looking Ahead

In 2015 U.S. based ETFs took in $242 billion and almost 20% of those flows went to currency-hedged international funds, which outperformed unhedged ETFs. So far this year, however, currency-hedged ETFs have fallen out of favor amid a weakened U.S. dollar and are underperforming. This is a fresh reminder to advisors and investors alike of the inherent market timing risk that comes with tactical exposures.

While currency-hedged ETFs are not buy-and-forget investments, they offer financial advisors an attractive way to manage the global uncertainties of currency ups and downs.

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