When diversifying into international markets, investors are exposed to currency risks or the ebbs and flows in the foreign exchange. Consequently, one may consider a currency-hedged exchange traded fund to help remove the risks from the equation.
“Currency risk can impact international equity return and risk, but full exposure is often assumed to be the neutral position with asset allocation decisions,” Deutsche Asset Management strategists led by Dodd Kittsley wrote in a research note. “Examining the role of currency risk from a long-term asset allocation standpoint finds that currencies can add risk to international equities without improving returns. Reducing currency risk exposure can potentially improve long-term portfolio outcomes, and may be considered the ‘new neutral’ for portfolios.”
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Unlike the stock market, currencies usually oscillate between a support and resistance level over the long-term. Inflation and monetary policy, for example, prevent currencies from increasing in value indefinitely. As one currency gains value, another has to depreciate to balance the effect out.
“Foreign currencies have not generated economically significant returns historically, and have added to volatility of international equities,” Deutsche strategists said. “Hedging international equities, at least partially, can therefore be expected to help improve portfolio outcomes.”
When assessing an international investment, investors should consider the return of equities in local currency terms and the return of the currency exposure.
[related_stories]Equities will typically generate a positive return over the long run – looking at the 30 years of monthly returns for seven MSCI developed market equity benchmarks and 15 years of monthly returns for some of the largest emerging market benchmarks, Deutsche Bank found that the average return for all equity markets, with the exception of Japan and Taiwan, was significantly above zero.
In contrast, looking at the same currencies of the international developed and emerging markets and their average monthly returns against the U.S. dollar over the same time periods, Deutsche found that foreign currency returns were not statistically different from zero.
From this, we see that foreign currencies will likely not add to portfolio returns over the long run, but they may add to risks over the short-term.
“For both developed and emerging markets, equity volatility is the dominant term, and currency volatility is significant and additive to total investment volatility,” the strategists said.
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Consequently, if one controls for currency exposure, international investors may be able to diminish risk associated with volatility in the forex market.
“We believe that hedging the currency risk of a portfolio of international equities can be expected to lower portfolio volatility without impacting expected returns,” Deutsche strategists added.
ETF investors interested in the currency-hedged strategy have a number of options available. For instance, Deutsche X-trackers MSCI Japan Hedged Equity ETF (NYSEArca: DBJP) and Deutsche X-trackers MSCI EMU Hedged Equity ETF (NYSEArca: DBEZ) provide targeted exposure to Japan and the Eurozone, respectively. Additionally, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF) provides access to the broader developed Europe, Australasia and Far East.