One of the cardinal rules of investing is to diversify. From different currencies, to regions, to asset classes, it is always better to spread risk. However, what may appear to be positive returns can quickly become disappointing when converted back into the investor’s domestic currency.
Without currency hedging, the profit is simply the return from the portfolio plus the foreign currency return, which can often work against the investor once the exchange rate is factored in. A currency hedge works to reduce or eliminate the risk of a poor currency exchange rate.
This is particularly a problem for UK consumers looking at foreign equities. Even if the overseas investment performs well, the pound has continued to strengthen, so returns can lose a great deal of value when converted back to sterling.
The structure of ETFs makes them particularly good vehicles for hedging investments. Because they are traded actively on exchanges, they are highly liquid, and their ability to access a range of asset classes allows for easy diversification. ETFs can also act like derivatives – such as options or futures – to take long or short positions but at a much lower cost than traditional financial tools.
Geopolitical risk and unpredictable exchange rates have made overseas investments tricky, making these products an increasingly popular option.
Top prospects
ETFs are able to track the performance of a number of indcies with corresponding currencies, leaving investors with a wide array of options. A number of the top 20 best performing currency-hedged ETFs, shown in Table 1 focus on the Japanese index or European markets, and often hedge against the euro, Canadian dollar, or Japanese yen.
The focus on Japan is likely due to the ongoing ramifications of Abenomics – the massive economic stimulus program initiated in 2013 by Japanese Prime Minister Shinzo Abe. Following the stimulus – aimed at reversing Japan’s chronic deflation and resolve larger macroeconomic problems – Japanese stocks rose by 53 per cent in 2013, but the Yen depreciated against the US dollar benchmark. This meant that unhedged investments lost a great deal of value.
The iShares Japan Fundamental Index CAD Hedged TR, denominated in sterling, is currently the best performing ETF that includes currency hedging. The fund tracks the FTSE RAFI Japan Canadian Dollar Hedged Index, selecting constituents based on total cash dividends, free cash flow and total sales, as well as current-period book equity value.
The $107m (£69.6m) fund invests primarily in industrials at 21.7 per cent of the portfolio, followed by 20.3 per cent in consumer discretionary, 20.2 per cent in financials, and the rest between information technology, materials, consumer staples, utilities, healthcare, telecommunications, energy, cash and derivatives. The two largest holdings are Toyota Motor Corporation and Mitsubishi UFJ Financial Group, both based in Japan.
Premium purchase
These products should help protect investors’ returns against unforeseen risk, so naturally they come at a cost. Currency-hedged ETFs are more expensive, yet often outperform the unhedged counterpoints to the point that the extra cost is more than made up for.
Currency-hedged indices for global markets, developed international markets, emerging markets, and numerous individual countries have substantially outperformed their unhedged equivalents since the beginning of 2014, according to research from BlackRock’s ETF provider iShares.
ETFs tracking Japan proved to have some of the most significant differences in returns, as Japan trackers hedged to the US dollar returned an average of 29.8 per cent, compared to the unhedged return of 11 per cent. The figures for ETFs in Europe’s markets were also startling, as the unhedged version lost an average of 2.6 per cent, while the hedged ETF returned 22.1 per cent.
While currency hedged ETFs come at a premium, they have proven to be worth the opportunity cost, protecting portfolios from potentially losing out on added return if the foreign currency appreciates against the investor’s local currency.
ETFs are becoming increasingly accessible to the average investor, yet many may not be aware of the potential losses their funds can make due to unfavourable exchange rates. Though they are more expensive than their unhedged counterparts, currency-hedged ETFs are likely to make up for the added cost in better returns over time.
Five questions to ask
1. Why should I purchase currency-hedged ETFs?
Currency-hedged ETFs protect investments that are in the consumer’s local currency against the exchange rate risk from a foreign currency. This aims to maintain an overseas investment’s value after it is converted back into the domestic currency.
2. How much should I expect to pay?
The charges will vary depending on the benchmark that the ETF tracks and the provider, but currency hedged ETFs are often more expensive than there non-hedged counterparts. This is because of the added level of protection against exchange rate risk that regular ETFs would not have.
3. Are they worth the extra charge?
While it is impossible to predict changes in exchange rates, currency-hedged ETFs have consistently outperformed their benchmark over the past year. Though they may cost more initially, currency hedged ETFs are likely to make back any extra fee over time.
4. Is it worth buying them in the UK?
Not if you are an investor based out of the UK. The point of these ETFs is to defend against changes in exchange rates that could cause the investment to lose value when converted back to the investor’s local currency, so there no reason to hedge currency if the fund is based in the desired currency.
5. Are these products physical or synthetic ETFs?
Because these types of ETFs use derivatives to hedge against currency risk, they cannot be physical replications. Synthetic ETFs use derivatives to track a given benchmark and/or spread risk, so all currency-hedged ETFs will be synthetic.
