Currency Hedging
Currency exposure can also be hedged using ETFs. Non-U.S. investments (or an investment outside of your own home currency) create an additional element of risk: currency fluctuations.
Assume you’re a U.S. investor and buy a stock listed in Canada; your stock return is not only determined by the performance of the stock, but also the performance of the USD/CAD currency exchange rate. If the U.S. dollar (USD) appreciates it will hurt your stock return, since when you convert your proceeds from the Canadian stock back into U.S. dollars, you will need to pay more for those U.S. dollars.
If the USD depreciates, it helps your stock return—either to offset the capital losses or add to the capital gain of the stock. Therefore a hedge is really only needed to compensate you (hedge) for a rally in the USD; if you think your foreign currency will appreciate (USD depreciates), it makes sense to avoid hedging.
When you buy a foreign asset, you’re buying that foreign currency as well, and selling U.S. dollars. Therefore, you need to buy an equivalent amount of USD—which can be done through an ETF—to help net out the foreign currency fluctuation. In this case, you could short-sell the CurrencyShares Canadian Dollar Trust (FXC), which means you are effectively selling your Canadian dollar exposure, and buying your USD back.
A more general strategy is to buy the DB USD Index Bullish (UUP), which simulates being long USD future contracts versus a basket of currencies; this is effective if you have multiple assets in different currencies around the globe and want to hedge with one transaction.
Currency ETFs are available for commonly traded currencies.
The Bottom Line
In addition to serving as portfolio building blocks, ETFs are effective hedging vehicles for those looking to tame volatility, guard against inflation, net out foreign currency risk or simply take advantage of a timely opportunity in the market.
ETFdb offers a comprehensive and original ETF database and analytical consulting services for advisors and investors, as well as a free newsletter. Learn more about their services by visiting ETFdb.com. Disclosure: the author had no positions in the securities named in this article at the time of writing.