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.
