Currency factor played a critical role in regards to the portfolio rate of return. Sometimes its impact exceeds the underlying asset itself. So it's no wonder currency hedging concepts and related ETFs are so popular these years. Let's take Japan equity as an example, in terms of the treatment towards currency exchange rate risk, there are at least 4 versions of ETFs (let's put aside the difference of underlying indices): unhedged, 50% hedged, 100% hedged, and dynamically hedged. Naturally a string of questions arise: How should we look at currency exchange risk? Why currency hedging ETFs are so popular in recent years? What kind of hedging strategy is the best?
- Currency exchange rate risk is everywhere
I learned this from personal investment experiences. Currency is affecting our portfolio return from several ways:
- Commodity prices are affected by pricing currency. I invested in the Market Vectors Gold Miners ETF (GDX) for a while; as gold price are denominated in U.S. dollars, the price of GDX is negatively correlated with U.S. dollar index.
- International equity prices are affected by the currency exchange rates. I invested in the iShares MSCI Spain Capped ETF (EWP), but I have double layer exposure to currency risks: I resides in Canada and Canadian dollar is my income tax reporting currency, so the CAD/USD matters to me. EWP is denominated in the U.S. dollar but Spain uses the Euro, so the USD/EUR matters too. If tax implication (such as withholding tax) is considered, this kind of investment is complicated for retail investors.
- Company's income sources are affected by the currency exchange rates. I invested BEP.UN, a LP unit traded on the Toronto Exchange. In 2015 its unit price decreased substantially, so I listened its conference calls. The company's income come from several places: Canada, U.S., Europe, and Brazil. The sharp devaluation of the Brazilian Real and the gloomy outlook of the Euro dragged the valuation of BEP.UN. If you don't look into the details of the company income's geographical distribution, you won't know why the share price changes.
So my personal takeaway from those experiences and lessons are, always consider the currency factor your portfolio may have. Try to dig a few layers further to know how your holdings will be affected by currency factor. This is very important.
- Preconditions of Currency Hedging ETFs
Currency hedging is a risk management tool. It is used with cost and have some preconditions:
- Currency pairs are free float and highly liquid. If a currency such as the Chinese RMB Yuan is not free float, it is very difficult or expensive to adopt currency hedge strategies.
- Foreign currency's interest rate is around zero. This will eliminate the interest rate difference factor and make the hedging simplified. Otherwise there is a delivery of interest rate difference between the two parties. If the foreign currency's interest rate is very high, such as India, the hedging gain cannot cover the interest rate difference, thus make the hedging infeasible.
So from the view angle of the U.S., we can see most of the currency hedging ETFs are invested in Japan, Europe.
- Which hedging strategy is the best
Currency hedging is a very good example of product innovation in the ETF industry. Since 2006 WisdomTree (NASDAQ:WETF) launched the first currency hedging ETF, the WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ), the evolution of currency hedging is never stopped. In 2005, IQ index launched 50% hedged ETFs. In the beginning of 2016, WisdomTree launched dynamic hedging ETFs. Let's take Japan as the example again, there are 4 different versions of Japan total market equity ETFs: the unhedged iShares MSCI Japan ETF (EWJ), the 50% hedged IQ 50 Percent Hedged FTSE Japan ETF (HFXJ), the 100% hedged DXJ (WisdomTree), and the dynamically hedged WisdomTree Dynamic Currency Hedged Japan Equity Fund (DDJP).
I'd like to use a simplified illustration to explain my understanding of those strategies.
We can see there are 4 strategies altogether. Among those 3 are static strategies and 1 is dynamic.
- Unhedged. This strategy means you are fully exposed to the exchange rate risk. You may suffer from the depreciation of the foreign currency you invested, while you may also benefit from the appreciation of the foreign currency. If you have no idea about the trend of the foreign currency exchange rate and are willing to take the risk, this is your choice.
- 50% hedged. You still have no idea with the exchange rate direction but want to do something. 50% hedging is like a straddle strategy in options. You pay a bit of cost to participate the exchange rate movements.
- 100% hedged. You don't want to participate the game of currency movement. You just want to play the pure game of the underlying assets themselves. 100% hedging strategy filtered the currency factor and make it a pure game. Or if you think the foreign currency will depreciate and you need the protection, this is your choice.
- Dynamically hedged. WisdomTree uses a rule based method to decide how much should I hedged at any given time. The formula watches three factors: interest rate, momentum, value, which are equally weighted. Under this method, the ratio of hedging could be any percentage between 0 to 100%. This is why it is called dynamic.
Debates about the effectiveness of currency hedging have never been stopped. It's not easy to say which strategy is overwhelmingly superior than the rest. From the 4 ETFs chart above, we can see that due to recent appreciation of Japanese Yen, the unhedged EWJ outperformed the 50% hedged HFXJ and 100% hedged DXJ. With the direction of exchange rates become more and more difficult to predict, maybe the 50% or dynamic strategies are better choices. As those two funds are rolled out a very short period of time, we still need to watch for some time.
Disclosure: I am/we are long EWJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.