How ETF Currency Hedging Works

Without hedging, an investor’s return is simply the foreign portfolio return plus the foreign currency return. A currency hedge takes the foreign currency return out of the equation

Caroline Gutman 18 September, 2014 | 12:47PM

Picking the right ETF in today’s landscape is hard enough. Between selecting an index, a fund provider and a replication method, there are many choices to make. But an additional decision investors may want to consider when buying an ETF exposed to foreign assets is whether to protect their investment against currency fluctuations. The easiest way to do this with ETFs is by buying an ETF with a built-in currency hedge.

Without hedging, an investor’s return is simply the foreign portfolio return plus the foreign currency return. A currency hedge aims to take the foreign currency return out of the equation.

Currency hedging as a tool is nothing new. Investors have long protected against currency fluctuations by buying derivatives or short positions to protect their portfolios. But built-in currency hedges can simplify the process, and European ETF providers have recognised the appeal. Forty five currency-hedged equity ETFs have launched in Europe in the last 12 months, bringing the total number available to more than 70.

And currency-hedged ETFs are gaining a lot of traction. Fund flows of European currency-hedged equity ETFs over the last year reached £4.4 billion, most noticeably into currency-hedged Japan ETFs on the back of Abenomics – Prime Minister Shinzo Abe’s economic measures and weak yen policy contributed to almost half of the inflows. In the last twelve months, the iShares MSCI Japan EUR Hedged ETF (IJPE) alone saw inflows of £510 million – the most of any currency-hedged equity ETF – while the iShares MSCI Japan – B Acc ETF (CSJP) saw outflows of £80 million.

Investors who lived through the late 1990s and early 2000s know how dire the effects of currency devaluation can be on a portfolio. In 1997, the value of the Thai baht dropped by 20%, and the Philippine peso, Singapore dollar and South Korean won quickly followed, crippling the portfolios of investors with exposure to Asian equity, and emerging markets equity more broadly. Then in 2013, Abenomics sent the yen down by about 18% and 19% against the U.S. dollar and pound sterling, respectively. As a result, while the MSCI Japan in yen gained 55% that year, the iShares MSCI Japan ETF in pound sterling advanced by only 24%. On the other hand, the iShares MSCI Japan GBP Hedged ETF returned 52%.  

A currency-hedge, however, does come at a cost. For example, the iShares MSCI Japan currency-hedged ETFs charge a TER of 0.64% whereas the iShares MSCI Japan B-Acc charges a TER of 0.48%.

There is also the cost of rolling forward contracts, which is typically done on a monthly basis (some providers offer daily rolling, although at an even higher cost to investors). Investors should also be aware of indirect costs related to potential inaccuracies of the currency hedge due to market volatility and intra-monthly (or intra-daily) changes of the underlying benchmark.

And then, of course, there is the opportunity cost: potentially losing out on added return if the foreign currency appreciates against the investor’s local currency. For instance, a sterling investor and a euro investor who had hedged against the US dollar last year would have missed out on 2% and 4.3% of additional return, respectively.

All in all, it is important to bear in mind that predicting currency movements remain a difficult–if not impossible-exercise, especially over long periods of time. Several studies have even found that conditional expected excess returns on currencies in the long-term are near zero and that long-term equity investors do not see improved returns from currency hedging. For this reason, we believe that using currency-hedged ETFs probably work best over shorter time periods and on a tactical basis.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
iShares MSCI Japan - B Acc GBP11,169.65 GBP0.37
iShares MSCI Japan EUR Hedged45.47 EUR0.06

About Author

Caroline Gutman  is a passive fund analyst for Morningstar

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