ETFs continue to open up the doors to international markets that were previously too difficult, or costly, to access for mainstream investors. While many have taken advantage of this by adding geographic diversity to their portfolios, few have considered the impact of currency fluctuations on their foreign, non-U.S. dollar denominated investments. Whether they realize it or not, investors with exposure to Brazilian or Japanese stocks, for example, are also exposed to the currency risks associated with the Brazilian real and the Japanese yen respectively. As such, Martin Kremenstein, Director and Chief Investment Officer of Deutsche Bank Commodity Services, recently took time to discuss the importance of currency exposure and how the lineup of currency-hedged ETFs offer a creative way to evade currency fluctuations without sacrificing international exposure [see King Dollar ETFdb Portfolio].
ETF Database (ETFdb): Can you explain the basic nuances associated with investing in foreign currency-denominated assets?
Martin Kremenstein (MK): When a U.S.-based investor invests in a foreign currency-denominated asset, like a foreign equity or bond, they are exposed to two sets of risk factors: the exposure to the asset itself (eg, Petrobras stock) and the exposure to the currency the asset is denominated in (in this case, Brazilian real). Both these risk factors drive return; for example, if a U.S. investor holds Petrobras stock and the stock does not move on a day, but the Brazilian real drops 10%, then that investor has lost 10%.
Currencies can have large fluctuations or move in long trends that do not necessarily correlate to the long term performance of the companies denominated in those currencies, especially when those companies are large, diversified, global firms. We think the majority of investors are seeking pure exposure to these companies in the same way they invest in domestic firms, and take the currency risk as an unknown or necessary bi-product. With currency hedged ETFs, they now have a choice.
ETFdb: How serious of a threat to bottom line performance does currency fluctuation pose for most investors?
MK: Currency fluctuations can make a huge difference to performance over time and in the short term can add a lot of unnecessary volatility to a portfolio. Consider this, roughly 100% of the outperformance of EAFE over the S&P 500 from 2001 to 2011 came from the devaluation of the dollar vs. developed market currencies. As the US Dollar starts to strengthen, investors will face a very large headwind on their returns from their foreign currency-denominated assets [see For ETF Investors, Currency Exposure Matters More Than You Might Think].
When investing in securities denominated in a foreign currency (or multiple foreign currencies as is the case with ETFs that invest in more than one foreign market), investors are exposed to fluctuations in both the value of the security in its local currency as well as to fluctuations in the exchange rate of that local currency relative to the investor’s home, or base, currency. Moves in the local currency relative to the U.S. Dollar can have an adverse impact on an investor’s portfolio. Currency hedging eliminates the currency risk.
A hedged strategy, such as ours, enables investors to lock in the returns they made during the long periods of US Dollar weakness, while maintaining the same equity holdings. If the US dollar strengthens, they will not give back that return. Currency has increasingly been recognized as a separate asset whose pricing is driven by fundamentals that can differ from those which impact the underlying asset market.
ETFdb: How do your “currency-hedged” products go about achieving their objective? Why does it make sense to use the ETF wrapper for investors looking to purse this sort of strategy?
MK: The ETF invests in the underlying equities in the index and then uses one month FX forwards to hedge out the currency exposure.
The ETF wrapper gives the investors the trade in one convenient, low-cost wrapper. The products are designed to be used alongside their unhedged counterpart funds, as they differ only in the use of the currency hedge. For many investors, this is the only way to access foreign equities without taking on the currency risks. FX overlay managers are only available to larger investors. The only other option retail investors have to avoid currency risk is to not invest in foreign equities.
ETFdb: Would you consider “currency-hedged” ETFs as a core, or more tactical holding for long-term, buy-and-hold investors? Risk-tolerant ones?
MK: I think they belong in the core, alongside unhedged foreign equities. Investors should decide how much currency risk they want to take and adjust the hedged to unhedged positioning accordingly. We are giving investors the ability to manage their currency exposure and the returns from it in an active manner, rather than just taking it passively. The key, here, is that investors currently have unhedged currency risk at their core and may be exposed to more risk than they would ordinarily be comfortable. By using our hedged ETFs, investors can either eliminate this currency exposure or temper it by finding a hedging balance they are comfortable with.
ETFdb: Broadly speaking, what trends are you seeing develop in the currency market amid this low-rate environment?
MK: I think we have seen the long run decline of the dollar (it was on a downward track for 10 years, which is usual for a currency trend) and we are now in an environment where it is entirely possible for the dollar to strengthen against the rest of the currency universe. In terms of investor trends, the retail investor is becoming increasingly aware of the impact currencies have on their returns, and as such, we want them to be able to make the informed, conscious decision with regard to the risk they take.
Bottom Line: The decisions on whether to accept the risks associated with currency exposure can seriously impact bottom line returns. Investors looking to tap into overseas markets, but are wary of potentially volatile and unfavorable currency fluctuations, ought to take a closer look at Deutsche Bank’s lineup of currency-hedged ETFs as they offer a compelling strategy with all the benefits associated with the ETF structure.
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Disclosure: No positions at time of writing.