Investors worried about currency fluctuations can look to currency hedged ETFs. Here’s how they work.
Currency fluctuations can be problematic for investors. If not hedged properly, gains in one part of a portfolio can be lost by the down cycles within currency values in another part of the portfolio. Investors in the US, for example, see this issue all the time with global or non-US investments eating into profit that had been realized at the US dollar level.
Exchange Traded Funds (ETFs) often use certain tactics to help investors reduce foreign exchange risk and provide an offsetting short position in the foreign currency to match the total notional principal of the underlying portfolio, typically through the use of a forward or a futures contract. A forward allows an investor to lock in the price of a currency today, regardless of fluctuations.
If the underlying currency of the foreign investment loses value relative to the home currency, the losses would be offset by the gain in the currency forward contract. The same is true in reverse: if the underlying currency appreciates against the home currency, the gains would be offset by the losses in the currency forward.
Single or Multiple?
When hedging an ETF’s currency fluctuations, investors have a choice: there are single-currency hedged ETFs and multiple-currency hedged ETFs. Single-currency hedged ETFs are more common. Examples of them include the iShares MSCI Japan ETF (EWJ ) and WisdomTree Japan Hedged Equity Fund (DXJ ). Many foreign ETFs have hedged versions that very often gain more than their un-hedged counterparts.
It stands to reason that the multiple-currency hedging ETF strategy looks at regions or company sizes. For example, if currencies rise against the US dollar, the actual makeup of the fund becomes less important if the fund’s manager was long on those currencies. The fund would have gained on these rising currencies.
Given the US’ strong economy and rising dollar, foreign investors are not only betting on the stocks and bonds of a particular country, but also on their local currency against the dollar. Other regionally hedged ETFs include:
- Db-X MSCI EAFE Currency-Hedged Equity Fund (DBEF ): This ETF tracks a broad market of countries in the EAFE region (Europe, Australasia, and Far East) without currency exposure.
- Db-X MSCI Emerging Market Currency-Hedged Equity Fund (DBEM ): Top countries in this fund include China, South Korea, and Taiwan.
Although currency hedged ETFs are a great way to remove currency risk, they do have their drawbacks. For example, in countries that are dependent on exports, such as Japan and South Korea, currency appreciation can have a severe effect on economic growth. As a result, non-currency hedged ETFs may be a natural hedge against currency-induced economic distress.
There are different types of currency hedged ETFs, including single and multi-currency hedged ETFs. A single-currency hedged ETF is when there is only one currency exposure from one country. Whereas a multiple-currency hedged ETF is when there is exposure to multiple countries with potential currency fluctuations. Both of these types of ETFs are a great way to hedge against foreign currency fluctuations risk.