Tackling Volatility with a 50% Currency Hedge | ETF Trends

By IndexIQ

The latest bout of volatility has not only been isolated to equities and fixed income but can clearly be seen with international currencies. When global issues arise, geographic diversification is important, which is why most employ an allocation to international equities, but currencies can also relatively strengthen and weaken affecting both returns and volatility.

For several years the U.S. Dollar has seen strength relative to developed currencies, meaning unhedged international equity exposure had faced a relentless drag on performance while providing the full volatility force of currency movement.

Beginning right at the start of the 4th Quarter 2019, developed international currencies rallied mostly in concert with an average return of roughly 3.5%, making unhedged international equity a very timely exposure for those 3 months, as unhedged would see the supplemental benefits of the currency return.

As market volatility picked up at the turn of 2020, and then accelerated with the COVID-19 drawdown, some interesting things began to happen with currencies. Relative to the US Dollar the British Pound strengthened, the Euro weakened, and the Yen strengthened. Then, around the end of February when the global spread of the virus accelerated, the Pound wavered between strength and weakness, the Euro strengthened over 5%, and the Yen dropped almost 8%, all in a matter of a couple of weeks. How can investors possibly decide between an unhedged or hedged exposure with the multi-directional volatility?

Currency Direction Divergence

Source: Bloomberg, as of 3/12/20. Past performance is no guarantee of future results, which will vary.

Considering market cap weighted exposure as represented by the FTSE Developed ex North America Index, the weighted movement of these top three currency exposures are shown below.

Top 3 Currency Exposures

Sources: Bloomberg, IndexIQ. As of 3/12/20.

Point to point, being hedged would have benefitted the investor, but what if assets were invested in September of 2019? The choice to hedge would have disadvantaged the investor relative to unhedged by as much as 3.5% in less than 3 months.

The clear solution, especially in the current environment, is to take the middle-ground passive exposure. Partial participation in foreign currency gains, partial protection of foreign currency weakness – in other words, 50% currency hedged. Utilizing the 50% currency exposure provides a way to step back from asset contribution, distribution, and rebalancing timing relative to where currencies are. It is arguably the most passive way to invest outside of the US.

Below exhibits the advantage of 50% currency exposure relative to full (unhedged) currency exposure over the past one- and three-year periods:

Source: Morningstar, as of 3/12/20. “FTSE 50%” represents the FTSE Developed ex North America 50% Hedged Index; “FTSE Unhedged” represents the FTSE Developed ex North America Index. See disclosures for index definitions.

Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

All investments are subject to market risk and will fluctuate in value. Investments in the securities of non-U.S. issuers involve risks beyond those associated with investments in U.S. securities.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Hedged: A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security. While hedging can reduce or eliminate losses, it can also reduce or eliminate gains. Hedges are sometimes subject to imperfect matching between the hedging transaction and the risk sought to be hedged and there can be no assurance that hedging transactions will be successful.

FTSE Developed ex North America 50% Hedged Index: The Index is an equity benchmark of international stocks from developed markets outside of the U.S. & Canada, with approximately half of the currency exposure of the securities included in the Index “hedged” against the U.S. dollar on a monthly basis.

FTSE Developed ex North America Index is comprised of large- and mid-cap stocks in Developed markets, excluding the US and Canada. The index is derived from the FTSE Global Equity Index Series (GEIS), which covers 98% of the world’s investable market capitalization. The FTSE currency hedging methodology allows exposure to the returns of the foreign assets in the index without being exposed to the volatility of the exchange rates against the US dollar. The index uses the WM Reuters one month (16:00 hrs London Time mid price) forward rates in the currency hedging calculation.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.