When tackling anything new, people tend to show some reservations. The same may be said about currency hedged exchange traded fund strategies but the investment may help investors diversify a portfolio.
According to a recent Deutsche Asset & Wealth Management research note, there are a number of common concerns that investors sometimes voice around currency hedging, including: Do I need to currency hedge when investing in companies with a global footprint? If I currency hedge, am I betting on currency moves? Will an American Depository Receipt (ADR) protect me from currency fluctuations? Is currency Hedging expensive?
For starters, currency hedging may be beneficial for an investment in a global company, DeAWM strategists said. For instance, German companies generate 75% of their revenue abroad. Almost a third of revenue generated by Anheuser-Busch Inbev was booked in U.S. dollars and only 6.6% was in euros.
Moreover, currency exposure at the corporate level can affect earnings and stock prices.
“Companies that operate globally tend to have more complex exposure to foreign currencies. Most large companies generate revenue and incur costs beyond the borders of their nation of domicile,” according to DeAWM.
While large companies may hedge currencies at the corporate level, the hedging tools that companies utilize do not diminish the impact of currency on an investor’s risk and return. Specifically, investors who did not hedge the currency exposure of a foreign investment would have found their returns reduced by a stronger U.S. dollar or weaker foreign currency.
Currency hedging is not a bet on currency moves. DeAWM argues that an unhedged international investment may even be seen as an active directional call on currency moves.
“The return of an unhedged investment has two components: local equity returns, and currency returns,” according to DeAWM. “Currency hedging aims to minimize the latter component, leaving the desired local equity returns isolated. Without hedging, investors are making an implicit bearish call on the U.S. dollar.”
Some may see ADRs as an alternative to currency hedging. ADRs are a common way for U.S. investors to access international equities, but the securities do not protect against currency risk. For example, JPMorgan sponsors a Honda Motor Company ADR that trades on the New York Stock Exchange. While Honda’s stock price rose 12% in the year ended June 2015, the ADR on the NYSE declined 7.4%, similar to the performance of Honda’s stock performance if converted to the USD after the yen depreciation.
Currency hedging is not an expensive endeavor to implement. However, DeAWM warned that interest rate differentials could be a greater cost to investors. If the USD rates are higher than foreign currencies being shorted, currency-hedged investors earn a greater difference between the two rate. On the other hand, if the USD rates are lower, investors pay the difference. Currently, with the Federal Reserve looking to hike rates while Japan, Switzerland and the Eurozone are implementing zero or negative rates, U.S. investors may be indirectly paid to hedge the currencies.
For more information on currency hedging strategies, visit our currency hedged ETFs category.
Max Chen contributed to this article.