When investing in international markets, most ETF investors are only looking at the possible opportunities or diversification effect provided by these foreign markets. However, many may be overlooking potential risks, notably the negative effects of foreign exchange or currency moves.
“With investors talking about currency hedging coming back, for us, it never went away. The US Dollar has strengthened considerably this year, while hedging also reduced volatility for most developed market exposure,” Luke Oliver, DWS Managing Director, Head of Index Investing, Americas, told ETF Trends.
“Perhaps the most important part of the currency hedging story is the carry yield investors can achieve when hedging. For example, developed country currency-hedged strategies have outperformed both unhedged and local stocks this year, as the hedges not only mitigate currency moves, they earn the interest rate difference between US rates and lower rates in other developed markets,” he added.
The Strength of Currency
A rebounding dollar or weakening overseas currencies are help currency-hedged ETFs, such as the Xtrackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF). As the U.S. dollar strengthens, foreign currencies would depreciate. If an investor holds a foreign stock that is denominated in the local currencies, a weaker foreign currency would translate to a lower USD-denominated return on that foreign equity exposure.
DBEF provides exposure to equity securities in developed international stock markets, while at the same time mitigating exposure to fluctuations between the value of the U.S. dollar and non-U.S. currencies.
Related: Europe ETFs Strengthen as ECB Cuts Rates, Signals More QE
So far this year, DBEF has increased by 18.0%, whereas the unhedged benchmark MSCI EAFE Index advanced 13.9%. The percentage difference between the currency-hedged and unhedged benchmark may be partially attributed to the 2.6% year-to-date gain in the U.S. dollar against a basket of currencies of the U.S.’s most significant trading partners.
Additionally, like Oliver pointed out, there is still a large interest rate difference especially when we compare the positive rates in the U.S. to the negative yields in Europe and Japan.
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