Getting emerging markets (EM) exposure can be a slippery slope to climb since the value of its assets will be affected by the strength or weakness of the local currency. This underscores the importance of having a currency hedging component, which investors can get built in to ETFs like the Xtrackers MSCI Emerging Markets Hedged Equity ETF (DBEM).
DBEM seeks investment results that correspond generally to the performance of the MSCI EM US Dollar Hedged Index. The fund, using a “passive” or indexing investment approach, seeks investment results that correspond generally to the performance, before fees and expenses, of the underlying index, which is designed to track emerging market performance while mitigating exposure to fluctuations between the value of the U.S. dollar and the currencies of the countries included in the underlying index.
DBEM will invest at least 80% of its total assets in component securities of the underlying index. The fund’s net expense ratio is 0.66%.
In a 2012 research report entitled “Why Currency Returns and Currency Hedging Matters,” it explains how currency rates can affect foreign investments:
“Currency returns (or exchange rates) are essential for the simple reason that they have a direct impact on the value of any foreign investment,” the report said. “Consider a US investor who purchased shares of Daimler AG, the German auto manufacturer, in May 2009 and then sold the shares in June 2010. The cost to this US investor in May 2009 would have been $3,670.70 (100 shares x 25.85€x 1.42 EUR/USD) when the exchange rate was 1.42 EUR/USD (a cost of $1.42 for each Euro), as shown in Exhibit 1.”
The report also discussed further why hedging currency risk is a must.
“One of the most well-known tenets in economics is that over the long term, there is an equilibrium real exchange rate between any two currencies,” the report added. “According to ‘purchasing power parity’ (PPP), exchange rates between currencies are in equilibrium when the purchasing power of each is the same in each of the two countries. 4PPP would imply that currency hedging isn’t worthwhile since exchange rates should revert back to this equilibrium rate. In reality, however, exchange rates can deviate substantially from this equilibrium rate, especially in the short run.”
Furthermore, the report highlighted events that are beyond an investor’s control that warrants the need for hedging:
- Central bank policy decisions
- Changes in inflationary conditions
- Changes occurring in the balance of trade
- Changes in the demand and attractiveness of financial assets
That said, before getting exposure to emerging markets, consider a currency hedging strategy. Or, opt for funds like DBEM where you have hedging built in to minimize downside risk.
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