We are currently in a big U.S. dollar currency cycle, with the greenback strengthening against a foreign currencies after years of falling behind. Consequently, ETF investors who are seeking diversified exposure should consider currency risks when investing in overseas markets.
On the recent webcast, Benchmarks Matter When Hedging Currency, Sebastien Galy, Director of Foreign-Exchange Strategy at Deutsche Bank, anticipates continued weakness in the euro currency against the USD in the months ahead.
Galy anticipates the European Central bank will expand its quantitative easing program to combat ongoing deflationary pressures, which will weigh on the EUR currency. In the Eurozone, the weaker commodity prices and slight strength in the euro has caused downward revisions to inflation forecasts, with risks to growth and prices on the downside.
“Within a risk management approach, we expect the ECB to react with a six month extension of QE in December,” Galy said.
Additionally, Galy argues that Federal Reserve, notably an expected interest rate hike in the U.S., will play a major role in the currency moves between the EUR and USD. Looking ahead, the strategist expects improved U.S. data in the fourth quarter and a slow monetary policy tightening.
“EUR/USD below parity into next year as the Fed slowly and belatedly tightens,” Galy said.
The EUR was trading at $1.1383 Tuesday, and Galy projects it could fall to $1.05 by the end of the year.
In the current big USD cycle, the currency strategist also calculates that we are currently just beyond the half way point and the Trade Weighted USD Index could still appreciate another 10% through 2017.
“Since 1973, the U.S. dollar cycle has ranged from six to 10 years, excluding current cycle,” Sean Edkins, Director and ETF RVP for Deutsche Asset & Wealth Management, said. “The current cycle of U.S. dollar strength likely began in 2011 during the European sovereign debt crisis.”
Edkins also explains that currency moves have contributed to a significant portion of international equity return and provided a persistent source of volatility. For instance, looking ahead, Edkins calculated as the EUR falls to $1.05 by the end of the year, the potential currency impact could result in a 5.9% decline in an unhedged investment. By 2017, Deutsche predicts the EUR to fall to $0.85, which could translate to a 23.9% negative impact on an unhedged investment.
With a stronger dollar and lower foreign currency outlook, investors seeking international market exposure may do well with a currency-hedged ETF strategy. [4 Things To Know About Currency Hedging]
For instance, John Nance, Director of Operations at Sterling Global Strategies, pointed out that the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF), a popular way for investors to diversify into international developed Europe, Australasia and Far East, or EAFE countries, has provided a better risk-adjusted return than unhedged EAFE ETFs in the current dollar bull market. [The Rise of Currency-Hedged ETFs]
“Our findings show the DBEF product outperformed the unhedged product by 38 bps while nearly cutting the standard deviation of the returns in half,” Nance said.
DBEF and other currency-hedged ETFs follow factor-based or smart-beta indices. Anil Rao, V.P. of Index Applied Research at MSCI Inc., explains that MSCI Hedged Indexes reflect the equity performance of an MSCI equity benchmark and removes the currency effect.
“The indexes aim to measure the impact on performance of hedging the currency exposure of MSCI international equity indexes against an investor’s base currency using a monthly currency Forward contract rollover,” Rao said.
Financial advisors who are interested in learning more about smart-beta, currency-hedged index strategies can listen to the webcast here on demand.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.