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  • Hedging ETFs and Foreign Currency Impact

    Posted by Carl from Chicago on December 14th, 2015 (All posts by )

    I wrote an article at Trust Funds for Kids about using hedged vs. unhedged ETFs for investing. If you are interested it is below the fold. The impact of currencies on investing is very large and linked closely with interest rate and Central bank activities.

    Recently the US dollar has strengthened against most foreign currencies.  This means that you could buy foreign stocks and they could do well in their local markets (for example, the Japanese stocks were generally up for a time) and yet you would have losses when your ADR or ETF was valued in US dollar terms.

    While you cannot generally hedge the currency risk in a single stock ADR (for example, Toyota), they now offer ETFs that give exposure to foreign markets but also hedge those currencies against the US dollar, so you receive their “actual” return (good or bad) rather than their actual return PLUS the impact of the rising or falling US dollar.

    For instance, let’s look at the VEU Vanguard ETF (one of my favorites, the Red line below) against a new ETF I started looking at, HEFA (the Blue line), over the last two years.  You can see that the total return was 1.1% positive in HEFA and 14.2% negative for VEU over that time span.  This difference is due almost totally to the rise in the US dollar against foreign currencies that make up the bulk of those stock indexes (the Euro, the Japanese Yen, the Australian Dollar, and the Canadian Dollar).  You can see that the peaks and valleys of the blue and red lines track together (they move in the same direction) but the red line sinks as the US dollar rises over the last two years.

     

    VEU vs HEFA Last 2 years

    VEU vs HEFA Last 2 years

    One negative impact of this, all else being equal, is that hedging costs money and this should be expected to drive up fees on your ETF.  The ETF for Vanguard (VEU) is 0.14%, which should be considered somewhere near rock bottom.  The HEFA ETF expense ratio is 0.35%, which is also very low, but higher than the Vanguard product.  This isn’t a perfect comparison because generally the Vanguard ETFs have the lowest expense ratios due to their member-owned structure.  HEFA is part of iShares which is now owned by Blackrock, a major competitor of Vanguard.

    It should be noted that the VEU and HEFA indexes aren’t exactly the same in terms of countries that they cover and weighting of markets but as you can see above they generally move closely in tandem and the majority of the difference is due to the impact of the US dollar against foreign currencies.

    This is of interest because the US Federal Reserve is considering raising interest rates soon, which theoretically would cause the dollar to rise which would make holding shares in other currencies less profitable.  Of course this is already priced into the dollar’s current level, which could mean in practice that if the Fed doesn’t move fast enough or make enough moves, the dollar would fall.  If anyone ever tells you that they can predict interest rates or currency moves you should not believe them; there is no reliable way to predict either one although there are mass industries of pundits attempting to do so.

    Thus for my “basic plan“, the question is, should you also consider adding currency-hedged ETFs and not just the two basic ETFs (VEU and VTI).  The question is whether to replace part of your VEU allocation (how much you buy) with something like HEFA (there are other ETFs, but this seems to be a pretty good one, with a large base of investors and from a company like Blackrock which isn’t going away any time soon).  Here’s what would happen – if the US dollar falls against major foreign currencies, you are going to make less money than you would otherwise if you hedge it.  If the US dollar rises, you will make more money than you would otherwise with the hedged product.  Also note that the hedging may not be perfect, but would likely shield you from the vast majority of the impact, especially on major currencies like the Euro.

    I think that this is getting a lot of play in the financial press right now and I predict that at some point these products will be mainstream.   It took a long time to move from “active” to “passive” investing and it has taken many more years for ETFs to begin to take a large share of new investments away from mutual funds.  This is another long term trend that started on the margin (there were very few currency hedged funds a couple years ago when I looked, and they were expensive) but is now going mainstream, and the additional expenses for hedging seem quite modest (0.14% vs. 0.35%).

     

    6 Responses to “Hedging ETFs and Foreign Currency Impact”

    1. Mike K Says:

      Oh Oh, Hedge funds are tanking.

      Investors retreated from the U.S. junk-bond market for the third straight trading day and stocks of large asset managers were hit by heavy selling, a sign that the deepest turmoil in financial markets since summer is intensifying.

      Some investors reported difficulties selling lower-rated bonds quickly or at listed prices, though others said the market appeared to stabilize somewhat after the record plunge in prices on Friday.

      While the market for the highest-quality bonds remains intact, there are signs across Wall Street that investors are losing confidence in lower-quality bonds and the firms that most actively deal in them.

      Fasten your seat belts.

    2. Grurray Says:

      Most hedge funds don’t really hedge, i.e protecting their portfolio in the options markets. The funds are just vehicles for the fund manager’s investment whims. Options as a defensive strategy are basically insurance, and that doesn’t make headlines or buy yachts.

      Hedging for currency fluctuations sounds interesting. I see the HEFA ETF’s top three holdings are Swiss companies. Their hedging undoubtedly helped them on the day earlier in the year when the Swiss National Bank out of the blue decided to torpedo the foreign exchange markets.

      Although all the central banks are swindlers in their own way, the Swiss central bank has a history of criminal activity. Any strategy to shield your money from these lecherous thieves and charlatans is a good one.

    3. phwest Says:

      Investing in overseas markets does two things : first, it diversifies your holdings so that you have some protection against a situation where the US economy struggles relative to the international market. The fact that large-cap stocks are also heavily multi-national dilutes the value of this, as US-based companies earnings include a large fraction from non-US operations, while the reverse is true of many major foriegn companies. But hedging this exposure certainly makes sense in the short term, particularly if you are invested for dividend income.

      However, the other thing that overseas holdings do is hedge against local currency stupidity. This is generally more of a concern for investors in countries with more unstable currency regimes (see Argentina, Brazil), but I don’t think it is unreasonable to wish to protect against this risk in the US as well. Think of it as an alternative to holding gold – it doesn’t provide the protection against a truly international meltdown, but it certainly hedges against US-specific issues. If you are investing internationally with this objective, then you absolutely do NOT want hedge currency, since that exposure is what you are looking for.

      As with many investments, this is a hot topic now because it paid of so well last year as the dollar strengthened. Personally, nothing annoys me more than having an advisor pitching a hedge (as one of mine did) after a 10-15% movement that the hedge would have covered. Horse, barn door, and so forth. Personally, I am inclined against this for any long-term holdings (I’ve been watching currency markets for a long time, and major currencies have remained within ranges – broad ranges, true, but ultimately bounded) as it doesn’t make a lot of sense to pay to hedge what is primarily a short-term volatility risk. But if your horizon is shorter term – particularly if you are spending the dividends – then it is certainly reasonable.

    4. Grurray Says:

      “then you absolutely do NOT want hedge currency, since that exposure is what you are looking for”

      According to the website the HEFA ETF holds a variety of currency pairs, that it moves around in the futures markets to create the hedge. This is what the prospectus says:

      The Underlying Index sells forward the non-U.S. dollar currencies in which the securities of the Underlying Index are denominated in an amount equal to those securities at a one-month forward rate to effectively create a “hedge” against fluctuations in the relative value of the component currencies in relation to the U.S. dollar. The hedge is reset on a monthly basis. The Underlying Index is designed to have higher returns than an equivalent unhedged investment when the component currencies are weakening relative to the U.S. dollar and appreciation in some of the component currencies does not exceed the aggregate depreciation of the others. Conversely, the Underlying Index is designed to have lower returns than an equivalent unhedged investment when the component currencies are rising relative to the U.S. dollar.

      Correct me if I’m wrong, but this theoretically makes it currency neutral. If the US dollar rises then the foreign stock value declines (you’ll receive fewer dollars when it’s time to sell) , but this is offset by the currency hedge. If the US dollar declines then the foreign stock value goes up (you’ll receive more dollars when it’s time to sell), so the hedge is no longer needed and is allowed to decline.

      I add the caveat ‘theoretically’ because obviously resetting the futures contracts monthly isn’t going to exactly offset the daily volatility of the foreign exchange markets, but it seems to have worked when the SNB removed their peg which resulted in a 20 sigma move in the Swiss Franc, judging by the performance shown on their website

    5. phwest Says:

      Absolutely – I’m sure HEFA does a very good job of making their fund as currency-neutral as they can. I’m not arguing that you can’t hedge currency risk, just that there are reasons not to. The first being the cost, and the second being that holding non-dollar denominated assets is a hedge in its own right – in this case a hedge against the dollar being devalued relative to the foreign currency (as happened with the Yen in the 80s for example). Which risk you want to protect against will depend on your circumstances, as well as your own sense of which risk is a bigger concern.

      In the context of personal finance, I think it makes sense to have some foreign currency exposure (after all, everyone buys at least some imports, so you’re hedging those costs). The level varies, but I lean towards somewhere in the 10-20% range. So if your international holdings are 10% of your assets, I wouldn’t have them in a hedged fund. If they’re 50%, then sure, hedge most of that. Since most people tend to be light on international exposure anyway, that generally means don’t hedge.

    6. phwest Says:

      Disclaimer – I am not a financial advisor, the only assets I’m responsible for are my own.