When investing in overseas markets, some investors have turned to both international stocks and a currency-hedged strategy to even out foreign exchange fluctuations. Alternatively, people can look to partial currency-hedged exchange traded funds to help diminish currency risks, especially as the U.S. dollar experiences short-term volatility.
“Investors are being whipsawed by gyrations in the currency market,” Adam Patti, IndexIQ chief executive officer, said in an email. “Just on Wednesday, the U.S. dollar had one of its worst days in months, dropping nearly 2% versus the Japanese yen. This came on the heels of last Friday’s news that the Bank of Japan was moving to a negative interest rate policy, which at that time spurred a rise in the dollar.”
The greenback continued to slide Thursday, with the Dollar Index down 0.7% to 96.57. Among the major currencies, the euro currency gained 0.9% to $1.12. Additionally, the dollar weakened against the Japanese yen, depreciating 1.0% to ¥116.78.
The USD has been weakening ever since New York Fed President Bill Dudley said that financial conditions have tightened in the weeks since the Federal Reserve’s rate hike in December, adding to speculation that the Fed would hold off on four rate hikes this year.
“Even in less tumultuous times, correctly predicting the direction of the dollar versus major international currencies is an incredibly challenging proposition, but in a time of divergent central bank policies, and increased uncertainty about what different central banks (including our own) might do next, taking a currency neutral view when it comes to international equity investing may be worth a close look,” Patti said.
Many advisors are already implementing some form of a 50% hedge against foreign exchange moves by investing in two different ETFs – one hedged and one unhedged. However, this leaves investors with more work when rebalancing a portfolio, which would incur additional transaction fees as well as short-term capital gains.
A fully hedged portfolio historically diminished returns when the U.S. dollar weakened or international currencies appreciated – since a hedged portfolio shorts foreign currencies, investors would miss out on the added boost from stronger international currencies. On the other hand, an unhedged strategy historically underperformed when the USD appreciated or foreign currencies weakened – if international currencies depreciate, foreign currency-denominated investments would have a lower USD-denominated return.
Alternatively, investors may consider a 50% hedged/50% unhedged option, including the IQ 50 Percent Hedged FTSE International ETF (NYSEArca: HFXI), IQ 50 Percent Hedged FTSE Europe ETF (NYSEArca: HFXE) and IQ 50 Percent Hedged FTSE Japan ETF (NYS Arca: HFXJ). All three funds have approximately half their currency exposure of the securities in the underlying index hedged against the U.S. dollar on a monthly basis.
“Our research has shown that a 50% currency hedged approach can not only reduce the potential risk of misreading extreme currency movements (in either direction), but can also have a dampening effect on volatility,” Patti added.
Furthermore, ETF investors may also consider some new dynamic or adaptive currency-hedged international stock ETFs that recently began trading. For instance, BlackRock’s iShares has come out with the iShares Adaptive Currency Hedged MSCI Japan ETF (BATS: DEWJ), iShares Adaptive Currency Hedged MSCI EAFE ETF (BATS: DEFA) and iShares Adaptive Currency Hedged MSCI Eurozone ETF (BATS: DEZU). The Adaptive Currency Hedged ETFs may shift from 0% unhedged currency exposure to 100% fully hedged, depending on differences in interest rates, relative valuations, currency momentum and currency volatility.
WisdomTree offers the WisdomTree Dynamic Currency Hedged Europe Equity Fund (BATS: DDEZ), WisdomTree Dynamic Currency Hedged Japan Equity Fund (BATS: DDJP), WisdomTree Dynamic Currency Hedged International Equity Fund (BATS: DDWM) and WisdomTree Dynamic Currency Hedged International SmallCap Equity Fund (BATS: DDLS). The four Dynamic Currency Hedged Equity Funds will hedge currency fluctuations in the relative value of the foreign currency against the USD, ranging from 0% to 100% hedge based on interest rate differentials, valuations and relative price momentum of the foreign currencies compared to the USD.
Max Chen contributed to this article.