To Hedge Or Not To Hedge International? Revisiting The Question
Summary Currency-hedged ETFs have become a popular vehicle for international diversification with hedged currency risk. But the U.S. dollar trade has become a “crowded” and increasingly volatile trade. Does it make sense to utilize currency-hedged products in the current market environment or is it just “return chasing”? Currency-hedged ETFs have been around since 2010, but with the US dollar so strong relative to other currencies they have been gaining in popularity with investors seeking to reduce the currency risk in their portfolios. Through July there were more than 327 currency hedged products available globally, capturing an estimated $118 billion in assets. An estimated $47 billion have landed in currency-hedged products this year, representing 40% of passive flows into international products. Below is a table with the names and tickers of the largest currency-hedged ETFs: Source: ETF.com Currency-hedged international equity products can boost returns when the local currency is weakening against the dollar, but they can also be a drag on returns if the dollar weakens. Most currency-hedged ETFs use “currency forwards” to hedge currency exposure and if the trade is executed correctly, currency exposure is neutralized. The foreign currency markets can be very volatile. Just this week, the Euro rose four cents in one day against the dollar after the European Central Bank’s stimulus measures came in well short of expectations. As another example, the Swiss franc jumped by 30% in a matter of minutes last January. And then of course there was China’s currency devaluation over the summer. And ever since the global financial crisis, foreign currency volatility has markedly increased in the era of quantitative easing (QE) and monetary policy intervention. This trend has been exacerbated over the last few years thanks to the growing economic divergence between the U.S. economy and the rest of the world’s. The U.S. has emerged since the financial crisis as one of the stronger economies on the globe. Economic and currency divergence has resulted in a substantial difference in returns between hedged and unhedged investments in several regions including Developed Markets (EAFE), Emerging Markets (EM), Europe, Japan, and Germany as depicted in the chart below. (click to enlarge) Source: Bloomberg So given the fact that it is likely the Federal Reserve will raise interest rates this December, further strengthening the position of the dollar, it seems like a “no brainer” to hedge international investments. But is it? The sharp spike in the Euro relative to the dollar recently illustrates that the dollar trade is a very “crowded” trade and as a result also subject to wide swings in volatility. Even Fed Chair Janet Yellen said much of the divergence is already priced into the dollar. So by utilizing currency-hedged ETFs, as an investor are you merely piling into an already crowded trade and chasing returns? Long-term Risk Reduction Most academics would argue that over the long-term, currency investing is a zero-sum game and currency volatility cancels out over time. But currency movement does still add risk and volatility to investor portfolios. Investors unhedged to currency have excess exposure to the U.S. dollar and a rising dollar environment can severely compromise their international returns. By eliminating a form of uncompensated risk, hedging currency exposure over the long-term can serve to reduce risk and volatility. Short-term Tactical Trade As a short-term trade, currency-hedged products can also be utilized tactically to capture opportunities created by monetary policy shifts. Investors tactically playing the EU’s monetary stimulus trade for example, have been handsomely rewarded even considering the recent rally of the Euro relative to the dollar. Investors considering currency-hedged products must also consider the cost to hedge as part of their decision making process. Currency-hedged products typically have higher expense ratios and there is also a “carry cost” associated with the forward contracts. Much of the cost of the hedge is based on the interest rate differential, which provides an advantage to U.S.-based investors. Most funds reset their forwards monthly, so that may also inhibit the effectiveness of the hedge, especially in very volatile markets. But overall, currency-hedged products are a nice tool to have in the investment arsenal to help provide international diversification while mitigating currency risk. A 100% Hedge? So should investors hedge all of their international exposure in the current market environment given that much of the divergence and “flight to quality” trade has already played out? It is very easy for investors to mistime hedging. For example, there is historical evidence that the dollar tends to sell off initially after the first Fed rate hike, experiencing a “sell on the news” phenomenon. Analyzing the change in the dollar index after the last three rate hikes, the dollar has sold off the 3 months after the initial increase. (click to enlarge) A More “Balanced” Approach So perhaps the best strategy is a more balanced approach to help minimize downside risk without over penalizing upside opportunity. One such potential implementation is to allocate half (50%) of one’s international exposure to unhedged products and the other half (50%) to hedged. Along those lines, investors can create this paired exposure quite efficiently themselves with a 50/50 allocation. Another option is to utilize a 50/50 hedge ETF such as IndexIQ’s three 50% hedge products: the IQ 50 Percent Hedged FTSE International ETF (NYSEARCA: HFXI ), the IQ 50 Percent Hedged FTSE Europe ETF (NYSEARCA: HFXE ), and the IQ 50 Percent Hedged Japan (NYSEARCA: HFXJ ). IndexIQ, which is part of New York Life’s MainStay Investments, makes a compelling case for what they call in their white paper this “hedge of least regret.” And WisdomTree (NASDAQ: WETF ) recently filed for four dynamic hedging ETFs that will adjust currency hedging ratios ranging from 0 to 100 using currency-related quantitative inputs. In conclusion, currency-hedged products do indeed make sense over the long-term, but given that much of the strong dollar trade has already been priced into the market, hedging all of one’s international exposure, at least in the short-term, may be too much of a good thing.