Hoping to capture the tailwinds of last year’s rounds of quantitative easing, we saw investors put money in European and Japanese equities. But investors who ignored the embedded currency risks and left their positions unhedged found themselves unexpectedly undermined by a US dollar rally.1
The rally, which bolstered the strength of the US dollar versus the euro and the yen, meant that unhedged American investors lost money after converting those foreign-denominated assets back into dollars. We’ve seen those losses spark an interest in currency-hedged ETFs and the role they can play in portfolios.
To hedge or not to hedge?
Currency valuations can be influenced by multiple factors, including differentials in countries’ inflation and interest rates, as well as comparative levels of productivity, trade balance, deficit financing and political instability.
Lately, we have seen diverging macroeconomic policies have been the leading driver of currency valuations. As the Fed signals a potential shift into monetary tightening mode, other central banks are implementing their own quantitative easing (QE) programs by cutting short-term rates to try to stimulate growth, depreciating home currencies in the process.
Amid this flux, outsized currency moves are becoming commonplace. The unexpected January decision by the Swiss National Bank to remove the long-maintained peg between the Swiss franc and the euro caused the franc to rise 20% against the euro overnight. This created massive gains or losses as currency volatility spiked.2
More recently, China’s surprise decision to devalue its yuan triggered the biggest one-day drop in that currency since 1994, and began a sell-off that became a global market rout.
As investors look for growth opportunities overseas, we believe there needs to be a realization that we now live in a macro driven world—and currency hedging plays a role
in it.
How much currency exposure should be hedged?
Currency-hedged ETFs seek to limit a fund’s foreign currency return by investing in foreign currency forward contracts, which are rolled over monthly. Doing so is designed to remove a significant component of an exposure’s risk—currency volatility.
Over a long enough time horizon, say 15 to 20 years, currency’s impact on a portfolio may be minimal. But there are periods of mispricing in the market where currency can detract from a portfolio’s short-term return, and sometimes this can last for years.3 The figure below shows the potential advantage of implementing a currency-hedged strategy.
For investors who are looking to introduce hedging into their portfolios, a 50/50 hedged/unhedged approach may be a good starting point. This mix may lessen the most serious effects of today’s pronounced currency moves on portfolios, without becoming unduly exposed to US dollar strength if currency winds shift and the dollar stabilizes.
Currency-hedged ETFs: The best defense is a better offense
While hedging currency exposures was a strategy historically deployed by large institutional investors, an increasingly broad array of currency-hedged ETFs has democratized the offering, enabling investors to help manage currency risk.
Although the fed is considering tightening monetary policy over the long-term, as I mentioned before, central banks across the globe have been easing. This year, 57 central banks have implemented easy monetary policies and two—the European Central Bank and Bank of Japan—have conducted their own QE programs.4 As a result, we believe the dollar’s dominance should continue and, as shown through fund flows, have seen investors now betting that assets in European and Asian markets could potentially replicate the performance seen under the Fed’s QE and other ultra-accommodative programs.5
The Federal Reserve’s QE program and policies resulted in five areas of the financial markets performing well, on a relative basis:6
- Cyclicals
- Dividends
- Real Estate
- Credit
- Small Cap
SPDR’s suite of currency hedged ETFs seeks to provide exposure to those similar international market segments today, while also acknowledging investors’ currency concerns and potentially reducing volatility.