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.
However, potential investors should be aware that mitigating a potential source or risk by hedging currency exposure can also limit a potential source of return if the foreign currencies begin to appreciate against the U.S. dollar. For instance, over the past 40-plus years, Johnson points out that currency returns were a major contributor to total returns in foreign investments.
Nevertheless, investors should keep in mind that currencies follow a cyclical path – if one currency appreciates, another depreciates, and no single currency will appreciate indefinitely.
“By hedging foreign-currency exposure, investors can mitigate a source of risk–at the expense of a potential source of return,” Johnson added. “The trade-off between the two is an important one, and investors’ decisions will depend on a variety of factors, including but not limited to their return requirements, risk tolerance, investment horizon, and the costs associated with hedging currency exposure.”
Financial advisors interested in learning more about investing in the currency-hedged ETFs can register for the upcoming webcast, Have You Hedged Your Global Exposure?, scheduled for February 20.
For more information on investing globally, visit our global ETFs category.