Martin Kremenstein, Americas Head of Passive Asset Management at Deutsche Asset & Wealth Management, recently took time to discuss with us the key points investors should know about foreign currency risk, highlighting the benefits and potential drawbacks of hedging currency fluctuations [see King Dollar ETFdb Portfolio].

ETF Database (ETFdb): What is foreign currency risk?

Martin Kremenstein (MK): The foreign exchange market is one of the largest, most liquid markets in the world. Foreign currency risk is the exposure that investors have to changes in the value of one currency against another, for example USD vs. JPY. This exposure adds volatility to their portfolio and can lead to material changes in their returns. If you are a U.S.-domiciled investor, and have not hedged your currency risk, you will benefit when the dollar weakens and lose when the dollar strengthens.

ETFdb: What are the biggest misconceptions that international equity investors have about currency risk? Also, what are the “realities” regarding these “myths”?

MK: Many investors are not aware of the currency exposure they inherit when they invest in international equities. To buy a foreign security, your U.S. dollars are first converted to the currency that the security is denominated in (EUR, JPY, GBP, etc.) and you are left with two exposures, the security and the currency. You are long a stock and long a foreign currency. The biggest misconception is the belief that because the ETF or ADR you are purchasing is valued in U.S. dollars, you do not have currency exposure. The prices of ADRs and unhedged ETFs are determined by both the stock and the currency values. This means that the underlying stocks can rise in value, but your investment can fall in value due to moves in the currency. Hedged ETFs, such as the db X-trackers MSCI international currency-hedged ETFs offer a solution to this problem [see also How To Hedge With ETFs].

ETFdb: What are the benefits to hedging currency risk? Also, what are the potential drawbacks?

MK: Currency hedging protects investors from the movements between currencies. This can reduce volatility in the portfolio and allow investors to position for changing trends in the market. For the past 10 years or so, investors have done well by being short the USD and long on foreign currency – essentially holding foreign investments without the hedge. As the U.S. dollar strengthens, investors will give up some of that return. Our hedged products will allow investors the ability to continue holding the benchmark MSCI stocks but with the currency risk hedged. This means you can still access exposure to strong international firms without taking the downside to currencies, such as the EUR or the JPY, for example. Further, in an environment where the U.S. dollar is poised to strengthen against most major currencies, the hedged products offer the perfect way to avoid the downside while participating in the strengthening of foreign stocks as their economies benefit from having a weaker exchange rate.

ETFdb: Generally speaking, how do currency-hedged ETFs work?

MK: Currency-hedged ETFs work by taking the local currency exposure that their stock holdings create and use a currency forward to offset this risk. For example, if a fund held EUR 500mm of European stocks, the fund would sell a $500mm EUR forward to neutralize the EUR exposure. That forward would be EUR vs. USD and thus return the investors exposure to USD terms. Our funds reset this hedge each month to ensure the hedge matches the underlying exposure to currencies in the fund [see also How To Take Profits And Cut Losses When Trading ETFs].

ETFdb: Can you explain how the MSCI EAFE Hedged Equity Fund (DBEF B+) goes about achieving its objective?

MK: To further explore this, DBEF takes a long position in the stocks selected in the MSCI EAFE index. This contains developed country stocks from Japan, the United Kingdom, France, Switzerland, Germany, etc. Each month, the portfolio managers observe the exposure to each currency in the fund. We then sell the corresponding amount of that currency against the U.S. dollar using a one-month forward contract (a foreign exchange transaction that settles one month from now). Over the month, when the EUR, JPY, GBP, etc., change in value, there will be a benefit or loss to the stocks which will be offset by an opposite benefit or loss on the currency forwards. As a result, the ETF is largely unaffected by these currency moves. This enables the fund to take a pure play on the stocks. Often, weakness in a currency is bullish for the stocks in those countries, take the recent example of Japan. If you were currency hedged in Japan, you would have had the benefit of the stock rally without taking the loss on the weakening JPY.

When adding exposure to foreign equities, investors must consider the impact of currency fluctuations on their foreign, non-U.S. dollar-denominated investments. But thanks to the evolution of the ETF industry, currency-hedged ETFs offer a way to evade currency risk without sacrificing international exposure.

Disclosure: No positions at time of writing.