3 Things To Know About Currency Hedging

by: Dodd Kittsley

In the past month, non-U.S. developed markets equity ETFs attracted $11.2 billion. Pan-European equity, which I've discussed before on the Blog, brought in $4 billion. During the same period, broad-based developed markets equity added $3.7 billion, and Japanese equity exposures attracted $4 billion. We believe this trend will continue, and recently upgraded our view of Europe and Japan from neutral to overweight, as noted in BlackRock's latest Investment Directions.

As U.S. investors allocate more overseas for exposure to potential enhanced returns and reduced risk through diversification, many of them are unaware of how currency can impact the overall return of any international equity investment. In fact, currency can often contribute more to your return than the underlying security itself. I like to think of it as simply as

Total Investor Return = Equity Return + Currency Return

Your total return depends on both equity and currency returns, which are sensitive to economic, political and market events, and fluctuate over time. Below is an illustration of the historical effects of currency fluctuation, comparing the MSCI EAFE USD and the MSCI EAFE Local Index. As you can see, currency values can drastically impact total return. For example, the effect of currency in 2003 added 18% to an investment in the MSCI EAFE Index for U.S. investors. This was a time when the U.S. dollar weakened relative to other currencies, in particular the euro and the yen, and an unhedged investment paid off.

Another example is in 2005, where the effect of currency took 15% from an investment in the MSCI EAFE Index for U.S. investors. This was a time when the U.S. dollar strengthened relative to other currencies, and marked a year where hedged investment paid off.

Think of it this way: if you have a positive view of the underlying market equities in a foreign country, and a weak view of the U.S. dollar (i.e. appreciating local currency), you could select an unhedged currency investment, which most international equity ETFs currently offer. On the other hand, if you have a positive view of underlying market equities in a foreign country, and a strong view of the U.S. dollar (i.e. depreciating local currency), you could select a currency hedged product.

When the U.S. dollar appreciates, gains on international equity investments can diminish when converted back into U.S. dollars. This is especially relevant right now as we expect the dollar to strengthen this year. In a stronger U.S. dollar environment, hedged investments tend to outperform. Investors seeking pure exposure to underlying international markets can help to neutralize currency risk with a currency hedged investment or ETF. Here are three things to keep in mind:

1. The effects of currency fluctuations are more relevant today than ever before. Investors are beginning to allocate a greater proportion of their overall portfolios to international developed and emerging markets to avoid home country bias, or over-investing in one's own country. As my colleague Russ Koesterich points out in a recent post, investors often exaggerate the benefit of physical proximity and thus have overly-concentrated portfolios. Awareness of this bias has increased recently and combined with attractive fundamentals in markets outside the US - a reallocation outside the US is clearly underway.

2. Currency hedged investments historically have exhibited less volatility than unhedged. What's more, hedged products are now large, liquid and accessible to the average investor, offering international exposure while reducing the risk of currency fluctuations. Three new solutions include the iShares Currency Hedged MSCI Japan ETF (NYSEARCA:HEWJ), the iShares Currency Hedged MSCI EAFE ETF (BATS:HEFA) and the iShares Currency Hedged MSCI Germany ETF (NYSEARCA:HEWG).

3. Investors are beginning to take note of the value of currency hedged ETFs. In fact, currency hedged ETF flows hit a record $19.35 billion in 2013.

Most U.S. investors remain underexposed to international equities, yet most strategists agree that bigger opportunities exist outside beyond U.S. borders. A couple of years ago, investors didn't have the option of a hedged investment in ETFs. Today, they have more control to ensure that the product you select more accurately reflects your viewpoint. When investing in non-U.S. equities, consider both equity and currency return and where currency hedging may suit you the best.

Original post