Managing Currency Risk In International ETF Portfolio

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Includes: BKF, DXJ, EWJ
by: Marius Bausys

Summary

FX risk associated with international ETFs is frequently overlooked.

It is easy to identify and quantify currency exposures.

Investors should determine appropriate hedging strategy.

Investing in international markets has never been easier. The arrival of international ETFs has enabled investors to gain exposure to foreign stocks and bonds the same way as trading domestic securities. However, with the diversification benefit that international securities bring to a portfolio, there comes the currency risk as well. The latter is still little understood by a large number of investors and this article should shed some light on how to manage the FX risk in a portfolio that includes international ETFs. The three simple steps described below are a good start.

1. Identify the risk

The most important point is that the denomination currency of an ETF is almost irrelevant - it is the underlying securities that give rise to the currency risk. As an example, if a European investor buys iShares MSCI Japan ETF (NYSEARCA:EWJ), which is denominated in U.S. dollar ("USD"), 100% of the FX exposure is to the Japanese yen ("JPY") rather than the USD. This is simply due to the fact that the ETF has to convert USD to JPY before purchasing Japanese stocks.

All ETFs publicly disclose their geographic allocation, thus the first step is to check this data for each ETF in your portfolio. For instance, iShares MSCI BRIC ETF (NYSEARCA:BKF), which invests in four major emerging market economies, has 48.6% of its underlying securities denominated in Hong Kong dollars ("HKD"), 23.7% in Brazilian real ("BRL"), 17.3% in Indian rupee ("INR"), 7.9% Russian rouble ("RUB"), and 2.2% in U.S. dollars. From a U.S. investor's perspective, the HKD exposure can virtually be ignored as HKD has been pegged to USD since 1984. The 2.2% USD component can also be disregarded, which leaves BRL, INR and RUB exposures to be considered for hedging.

2. Quantify the risk

The next step is to aggregate all exposures at a portfolio level. Let's assume a US investor follows allocates 60% in foreign stocks and splits a $100k portfolio as follows: 40% in SPY, 30% in EWJ and 30% in BKF. Using analysis described in the first step, an investor can quantify FX exposures in a simple Excel table like the one below:

Value

USD

JPY

HKD

BRL

INR

RUB

SPY

$40,000

100.0%

EWJ

$30,000

100.0%

BKF

$30,000

2.2%

48.6%

23.7%

17.3%

7.9%

Total

$100,000

$40,660

$30,000

$14,580

$7,110

$5,190

$2,370

As of 27 November 2014

The table breaks down FX exposures for each security in a portfolio and aggregates currency positions. This already gives us a pretty good insight into FX components embedded in the portfolio and an investor can move to the third step. However, if one wants to take the analysis a bit further, I suggest checking implied volatilities:

Currency

USD

JPY

HKD

BRL

INR

RUB

12-Month Implied Vol.

-

10.7%

0.7%

13.3%

8.2%

24.0%

As of 28 November 2014

Then applying Value-at-Risk ("VaR") principles an investor can quantify potential losses. A statistical interpretation of the implied volatilities in the table above would be that the market is pricing in a 99% probability the exchange rate will not depreciate more than 2.33 standard deviations over the next year. So in the case of JPY, an investor should expect not to lose more than $30,000 * 10.7% * 2.33 = $7,479 due to currency depreciation in the next 12 months with a 99% confidence level.

3. Determine a hedging strategy

Once the FX exposures have been identified and quantified, it is time for taking action. There will be two primary factors in play that determine the hedging decision: investor's risk tolerance for the specific foreign currency and the cost of hedging.

a) Risk tolerance

Not every risk should be hedged. Sometimes it may prove to be too costly or inefficient.

It is always more expensive to hedge higher yielding currencies due to the cost of carry. For example, to sell RUB with a one year forward one would immediately pay out 12% due to the interest rate differential. In contrast, hedging a similar JPY exposure, the forward point differential would work in investor's favor and generate a 0.5% return.

Furthermore, some hedging instruments will have fixed notional amounts, which won't let you cover the exact amount. Therefore, an investor may want to set a minimum notional exposure or a VaR threshold for a specific currency and only take action if those levels are exceeded.

b) Hedging instruments

The most commonly used FX hedging instruments are the following:

  • Leveraged spot positions;
  • Derivatives (forwards, futures or options);
  • Currency ETFs.

The costs of all these instruments should generally be broadly similar but will largely depend on brokerage charges. You should check which products they can offer, transaction fees and capital requirements.

Another alternative is to invest in currency hedged ETFs. This is a simple option yet not always available. To illustrate the impact of a currency hedge, I have compared EWJ with WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) on a freely available investor resource InvestSpy:

Due to Japanese yen slide over the last few months, EWJ underperformed DXJ by 16% over the last 12 months. Such a performance drag is definitely substantial enough not to be overlooked. It is also worthwhile noting that the beta coefficient for DXJ is significantly higher than that of EWJ. This is because currency fluctuations are taken out of the equation, leaving pure equity exposure in place.

Conclusion

Summing up, it is important to be aware of the FX exposures inherent in your portfolio. An investor should quantify them and manage the potential impact of currency moves. In some cases, this may require putting an FX hedge in place, in others - one will be better off by doing nothing. At the end of the day, you should only hold exposures you want in your portfolio rather than place random bets.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.