In other words, you can trade currencies if you have opinions about them. But you haven’t been able to introduce foreign currency exposure to a portfolio by owning international stocks in a passive, capitalization-weighted, unhedged fashion and get reasonably compensated for the volatility the currency has provided.
Problems Of Purchasing Power Parity
Even without the extreme character of currency moves, trends can last over long periods of time. That means investors can have exposure to a falling currency for longer than they might have planned. While the concept of purchasing power parity suggests that, over time, different currencies should achieve similar purchasing power, the theory doesn’t always compare well to reality—at least not over the short run. Currencies don’t snap back to equilibrium and equivalent purchasing power quickly, argue the theory’s critics, including ETF provider WisdomTree. That means investors who don’t have multiple decades may still be well served by hedging their currency exposure.
Moreover, currency hedging isn’t expensive for funds to accomplish. For example, WisdomTree notes that it is only expensive to hedge currencies that have much higher short-term interest rates than the U.S. So while it may be expensive to hedge exposure to the Brazilian real, it isn’t expensive to hedge to the pound, euro or yen. In some cases, investors actually get paid to hedge. In those instances, not hedging is a more expensive proposition.
Not only is hedging inexpensive, but it has been good to do it in the past when foreign stock markets have been poised to rise. According to WisdomTree, international stocks in the past have delivered the strongest returns when foreign currencies have generally weakened. So an unhedged investor has been at risk for having gains in foreign stocks negated by foreign currency drops.
In that vein, the current global macroeconomic landscape is one in which countries with heavy debt loads that are trying to stimulate growth are voluntarily printing money, lowering interest rates and eroding the value of their currencies. The problem is that weaker foreign currencies spell losses for unhedged U.S. investors in foreign equities. Even if foreign central bank monetary policy only produces volatility, investors aren’t being compensated for it, argues WisdomTree.
Hedged Options
Among the WisdomTree currency-hedged foreign-equity ETFs are two dedicated to the broad European market—the Europe Hedged Equity Fund (HEDJ) and Europe Hedged SmallCap Equity Fund (EUSC). Both funds offer exposure to European stocks while hedging exposure to the euro. The former gives investors exposure to multinational firms such as automaker Daimler, technology and industrial firm Siemens and pharmaceutical giant Sanofi. The latter provides exposure to clothing maker Hugo Boss, telecommunications provider Eutelsat, and financial services company Edenred. Both funds carry an expense ratio of 0.58%.
Another option for investors is Deutsche Asset Management’s 27 currency-hedged ETFs. Among the broad ones are the Deutsche X-trackers MSCI All World Ex US Hedged Equity ETF (DBAW) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF).
With the former, an investor can get exposure to the entire world’s equity market, excluding the U.S., for an expense ratio of 0.40%.
With the latter, investors can gain access to the developed international markets in a hedged fashion for 0.35%. Among both funds’ largest holdings are food giant Nestle, pharmaceutical firm Novartis and energy producer British Petroleum. The All World ex US fund has emerging markets exposure, while the MSCI EAFE fund doesn’t.
Yet a third option from Deutsche is the Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM) for investors who would like to limit their exposure to emerging markets currencies while they hold emerging markets stocks. The fund charges 0.65%.
Splitting The Difference
While there are good reasons for currency hedging investments in international stocks, some investors may still view exposure to foreign currency as another form of diversification. Even though foreign currencies haven’t provided it in the past, they may in the future. Other investors may have a strong view on currency valuations, and may want to express the view that, say, the dollar will decline while they are simultaneously getting international equity exposure.
For these investors, an unhedged fund is the appropriate choice. One such fund is the iShares MSCI ACWI ETF (ACWI). This fund will track the index that stands as a proxy for the world’s stock market for the price of 0.33%. Other choices include the iShares MSCI EAFE Index ETF (EFA), which will track the main developed international markets index for the same 0.33%, and the iShares MSCI Emerging Markets ETF (EEM), which tracks the main emerging markets index for 0.69%.
Finally, investors who are not sure whether the historical conditions that made hedging worthwhile in the past will persist may wish to hedge half their exposure to foreign equities. Over long periods, currency moves may cancel each other out, but the AQR research suggests that even some hedging would eliminate a meaningful amount of volatility.
John Coumarianos, a former Morningstar analyst, is a financial writer in Laguna Niguel, Calif.