ETF Trends
ETF Trends

The surge of inflows to currency-hedged foreign equities shows an increasing level of currency awareness among U.S.-based investors.1 Today, many investors devote an increasing amount of time to understanding how currency risk will affect their portfolios. This is particularly true for Europe and Japan, where central banks are pursuing relfationary policies and there is essentially a free option to hedge. Given current interest rate differentials, investors actually earn a small amount of positive carry by hedging the euro or the yen against the U.S. dollar.

However, managing emerging market (EM) currency risk is more challenging. This is primarily due to higher interest rates in many emerging markets that drive up the cost of hedging. As an alternative, we believe that combining unhedged emerging market strategies—in either equities or fixed income—with a long dollar position against a basket of currencies2 may provide a “dirty hedge” that helps mitigate the risk of a strengthening U.S. dollar at a more reasonable cost.

Mechanics of Hedging

As we have explained previously, the cost to hedge a foreign currency is generally driven by the interest rate differential between the two currencies. In the case of emerging markets, higher growth and inflation rates have generally led to higher short-term interest rates than we are seeing in the United States. As a result, investors must pay the difference in order to be short the foreign currency against the dollar. If forward currency contracts did not incorporate this interest rate differential, investors could simply convert their U.S. dollars to a high-yielding currency like the Brazilian real, invest the proceeds in a Brazilian bank account earning an annualized 12.75%, then convert back to the U.S. dollar in one month locking in an arbitrage opportunity.

Why Not Hedge Directly?

One of the primary catalysts for hedging developed market currency risk is higher interest rates in the U.S. than in Europe and Japan. As we explained above, investors that are long U.S. dollars and short euros or yen currently can earn positive carry. However, in emerging markets (EM), this carry differential is reversed. In most emerging markets, there is an implied cost of being short an EM currency against the U.S. dollar. Using Brazil as an example, with short-term interest rates currently 12% or more above those in the U.S., investors interested in hedging their Brazilian real exposure would need to have the real depreciate by more than 12% per year to break even on their hedge. In our view, direct hedging of emerging markets only makes sense for a short-term trade in markets that have much higher interest rates. Historically, investors have simply sold out of emerging market assets instead of trying to hedge them.3

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