Investors who want overseas exposure can adapt to changes in the forex with unhedged or currency-hedged exchange traded fund options, but for long-term investors may be better served through sticking to one trade.
“There are valid reasons to invest in either currency-hedged or unhedged foreign-stock funds,” writes Karen Wallace for Morningstar. “The danger comes in trying to predict periods of relative strength for the U.S. dollar, and buying and selling hedged and unhedged funds in response.”
Currently, currency-hedged strategies are attracting robust inflows, with ETF options holding over $60 billion in assets under management, as investors try to hedge against weakening foreign currencies in light of the rapid ascent in the U.S. dollar. Moreover, many argue that the USD will continue to strengthen once the Federal Reserve hikes interest rates while foreign central banks adhere to loose monetary policies.
According to Morningstar data, over the short term, the appreciation in the greenback has led to improved risk-adjusted returns for foreign-stock investors with hedged foreign-currency exposures.
For instance, the underlying index for the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF) has increased 11.2% over the past year through June 30 while the MSCI EAFE has declined 4.2%. Meanwhile, the standard deviation of the currency-hedged index was less volatile at 8.41% over the past three years, compared to 10.52% for the EAFE benchmark. [Ride Global Growth with Developed Market ETFs]
Consequently, the depreciation in foreign currencies weighed on USD-denominated returns and contributed to greater swings in foreign stock indices and related unhedged funds. In contrast, the currency-hedged ETFs would provide a more pure play on the foreign markets, allowing investors to worry less about the direction the local currencies are trading against the greenback.
Nevertheless, potential investors should be aware that currency-hedged ETFs may underperform non-hedged strategies during periods when the USD is weakening or foreign currencies strengthen.
“In the seven years through December 2007, a falling U.S. dollar provided a boost to foreign equity funds,” according to Morningstar analyst Patricia Oey. “Over that time period, the unhedged MSCI EAFE Index outperformed the MSCI EAFE 100% Hedged to USD Index by 400 basis points, annualized.”
Additionally, investors should be aware that over long periods, risk-adjusted annual returns on hedged foreign stock portfolios have shown relatively similar risk-adjusted returns to unhedged foreign stock portfolios. Consequently, over the long-term, investors should worry less about currency movements as global currencies follow more cyclical movements – no single currency appreciates or depreciates indefinitely against other foreign currencies.
For more information on currency-hedged strategies, visit our currency hedged ETFs category.
Max Chen contributed to this article.