As investors become more comfortable with diversifying into overseas assets, some are beginning to take a closer look at currency-hedged equity exchange traded funds as a way to mitigate currency risk in foreign investments.
In the simplest terms, a U.S. dollar-denominated return for a foreign investment is equal to the foreign security’s return plus foreign local currency return, writes Ben Johnson, director of passive funds research for Morningstar. Consequently, changes in exchange rate between the greenback and foreign currency can affect U.S. dollar-denominated returns.
Japan, for example, witnessed the yen depreciate about 30% against the U.S. dollar ever since Shinzo Abe became Prime Minister in late 2012 and pushed the Bank of Japan for a more aggressive monetary policy to fight deflation and slow growth.
As the yen weakens and the Japanese economy expands, investors can take a look at yen currency-hedged Japan equity ETFs, like WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) and db X-trackers MSCI Japan Hedged Equity Fund (NYSEArca: DBJP), which rose 21.8% and 28.8%, respectively, over the past year. In comparison, the iShares MSCI Japan ETF (NYSEArca: EWJ), a non-currency hedged ETF, rose 18.7%. [Japan Stocks, ETFs Worst Among Developed Markets]
On the other end of the spectrum, the Brazilian real currency appreciated 34% in 2009, helping the iShares MSCI Brazil Capped ETF (NYSEArca: EWZ) jump 124% for the calendar year. However, over the past year, the real has depreciated 19%. The currency hedged component in db X-trackers MSCI Brazil Hedged Equity Fund (NYSEArca: DBBR) helped soften the blow in Brazilian equities over the past year, with DBBR declining 17.1%, compared to EWZ’s drop of 27.3%. [Deutsche Expands Currency Hedged Lineup With 3 New ETFs]
“These examples highlight two key points to keep in mind when considering currency exposure: 1) Currency returns can add or subtract from investors’ total return, and 2) currency fluctuations are volatile, are difficult to predict, and can be extreme in magnitude,” Johnson said in the article.