Investors may have allocated a portion of their investments to international markets as a way to diversify their portfolios, but they will face currency risks when seeking foreign exposure. Nevertheless, there are targeted currency-hedged exchange traded fund strategies to diminish the negative effects of foreign exchange fluctuations.

Now that the Federal Reserve has signaled it is embarking on interest rate normalization with more rate hikes expected in the year ahead, the U.S. dollar may continue to appreciate against foreign currencies.

“We suspect the strong performance of the dollar, particularly against the euro and the yen, where quantitative easing has weakened those currencies, has really shone a spotlight on the role currencies can play in an international investment,” Deustche Asset Management ETF Strategists Abby Woodham and Robert Bush said in a note.

Foreign exchange currency fluctuations are a significant driver of international investment risks, but it is one factor that investors can get a handle on. According to Deutsche Asset Management, from 1973 through 2016, leaving in currency exposure to an MSCI EAFE investment resulted in volatility on average 2.7 percentage points higher 91% of the time.

“Adding the currency does nothing for your return, but does increase your risk,” the strategists said.

Looking at rolling one-year returns and one-year volatility for the euro from 2000 through 2015, Woodham and Bush found that when you add an uncorrelated 0% return asset to a portfolio, the return number remains unchanged but the volatility increases, giving investors a higher reward-to-risk ratio for their investment portfolio.

“Under these assumptions it would be better to hedge,” Woodham and Bush said.

On the flip side, the strategists argued that correlation of -0.3 or lower with volatilities of 2% to 3% need to exist for a currency to be negligible for an international equity position. However, the Deutsche strategists contend that these levels of low dispersion have not been seen historically on a consistent basis, so international investors will experience the negative effects of currency risks.

Consequently, investors who are worried about the risks associated with wide currency swings in their international equity exposure, especially in the upcoming period of diverging monetary policies among global central banks, or Fed tightening and loose policies overseas, should consider currency-hedged ETF strategies to limit the currency risks.

For example, the Deutsche X-trackers MSCI All World ex US Hedged Equity ETF (NYSEArca: DBAW) provides broad market exposure by following a market cap-weighted index of international stocks, excluding U.S. exposure and hedging against depreciation in the underlying currencies against the U.S. dollar. The Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF) tracks developed Europe, Australasia and Far East countries. Additionally, the Deutsche X-trackers MSCI Emerging Markets Hedged Equity Fund (NYSEArca: DBEM) targets the emerging markets.

ETF investors can also find more targeted exposure through specific options. 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.

For more information on the currency hedging strategy, visit our currency-hedged ETFs category.

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