Investing in international exchange traded funds comes with risks for U.S. investors such as the obvious geopolitical factors - however, many investors can overlook currency risk. To mitigate these currency risks, some ETFs hedge their exposure to foreign currencies.
"Currency risk is a recurring phenomenon, as exchange rates are continuously changing and are functions of macroeconomic factors such as central bank regulations, interest rates, inflation, fiscal deficit, and trade deficit. Thus, investors have to keep in mind a host of other factors before considering international investments," Zacks Equity Research wrote.
ETFs that track overseas markets has made investing in foreign countries easy, and accessible for investors of every level. If there is a level of misunderstanding of how the financial product works, the probability of getting burned is higher. Anyone that can open a brokerage account can invest in an exotic foreign country in one step, however, there are government and border clashes, geopolitical risk and currency risk that can cut into returns, and quick.
The level of risk that is innate in the currency of a particular country is bundled into the chosen ETF. Volatility of the currency in which the invested assets are denominated can cut into returns due to the exchange rate of asset denominated currency versus the domestic currency. This is important as negative currency fluctuations can virtually wipe out the entire returns from investment abroad even if the asset class has been able to provide the desired rate of return, reports Zacks.
In other words, the rate of return for a U.S investor who has exposure in Brazilian equities in the iShares MSCI Brazil Index (NYSEARCA:EWZ) for instance, is 8%, denominated in the Brazilian real. If during that time the U.S. dollar appreciates 6% against the real, the true rate of return on the investment is actually 2%.
In response to this there are currency-hedged ETFs that can cut out currency risk against the appreciation of the greenback. However, investor interest in ETFs such as the following have lagged behind other funds that include the factor.
- WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ) The largest currency-hedged ETF with $204.66 million in assets. Up 0.89% year-to-date through September.
- WisdomTree International Hedged Equity Fund ETF (NYSEARCA:HEDJ) The fund has $24.82 million, and has returned 6.74% year-to-date through September.
WisdomTree Japan Hedged Equity ETF
Tisha Guerrero contributed to this article.