The Role of Currency Hedging in Investor Portfolios

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How should investors approach foreign currency risk in their portfolios? Joining me to share some research on that topic is Dan Sotiroff. He is an analyst in Morningstar's passive strategies research group.

Dan, thank you so much for being here.

Dan Sotiroff: Hi, Christine.

Benz: Dan, you have done some research on this idea of foreign currency risk and the role of hedging in investor portfolios. Let's just start by talking about how foreign currency changes relative to the dollar can affect investors' returns and potentially add some risk to their portfolios.

Sotiroff: You got at it there. Basically, what currency risk is, it's the change in foreign exchange rates that investors are exposed to. That can change the value of your foreign investment up or down. It can be a benefit or a disbenefit. If you want a really simple example of how this works, let's say, you wanted to buy shares in a foreign company, let's say, Nestle, for example. It's a Swiss-based company listed on the Swiss Stock Exchange and it trades in Swiss francs. As an U.S. investor if I wanted to buy shares in Nestle, before I actually buy those shares, I have to convert my U.S. dollars into Swiss francs. So, in doing so, I'm exposed to this additional transaction, this additional currency trade that's there implicitly. And that broadly implies not only to just shares of single stocks but bonds and any types of foreign mutual funds or ETFs that you would also purchase.

Benz: Let's talk about hedging and how it aims to try to remove that risk from the equation, the risk of the foreign currency moving in the wrong direction relative to the dollar.

Sotiroff: Basically, what currency hedging is, you are basically using a financial contract lock-in of future exchange rate, sometimes called the forward exchange rate. In doing so, you know what your future exchange rate is going to be. So, regardless of where exchange rates go, whether they go up or down, you are guaranteed an exchange rate in the future. In doing so, you eliminate that additional volatility of those changes in exchange rates fluctuating up and down, and that's essentially really how it works at the end of the day.

Benz: If you are investing in a mutual fund or an exchange-traded fund that is hedged back into the dollar, that's happening behind the scenes for you.

Sotiroff: Correct. These managers, what they are usually using is something called a forward contract. And in most of our passive vehicles, meaning like the ETFs and mutual funds that are using these strategies, they are usually using like a one-month forward contract. Every month they are going to update their hedging based on where interest rates are and the number of assets under management and other characteristics of a portfolio.

Benz: That sounds like a good thing to do in that it would potentially remove this risk from your portfolio. But let's talk about the costs that can go along with currency hedging, because it's not a free lunch, right?

Sotiroff: Probably the most obvious one, the most explicit one is the expense ratio. If you look at something like foreign large-blend funds, you can get an EAFE tracker or something equivalent for like 6 or 7 basis points right now. If you wanted to get a hedged portfolio of similar stocks, you can do that, but the cost goes up to about 35 basis points. It's more expensive, but the important thing to stress is, that's still a very low-cost option in the foreign large-blend category where the fees of an average actively managed fund are still considerably higher. You are coming out good at the end of the day, but you are going to pay up a little bit more for that hedging feature.

The second one is really little more taking place behind the scenes. It really gets back to this idea of a hedged return, and that's really driven by interest-rate differences between the countries. I don't want to get into the theory a little bit now, because it's a little wonky, but we do go over it in our recent white paper on this subject. If listeners want to check that out, they can get more into the theory there.

Probably the third area of cost that I really want to hit on here is the tax consequences. Because, like we said before, these funds are using monthly contracts, they are not subject to the same tax liabilities or the tax consequences that a traditional ETF or mutual fund will be. Anybody that's holding these in a taxable account will probably end up having to pay taxes when the hedging benefit pays off at the end of the day.

Benz: And there can be tax oddities with foreign stocks relative to U.S. anyway?

Sotiroff: Correct. There's some potential for things to offset there. It gets more complicated when you get into hedged vehicles is what I would say.

Benz: You concluded though that investors probably are underrecognizing the benefits of using hedged foreign stock products in their portfolios. And maybe one of the things that they are underrating is the extent to which the costs on some of those hedged products have come down.

Sotiroff: They have come down a lot and there are still some out there that are actually really cheap. They are newer, so we don't really cover them at this point in time. But there's a lot of potential for that area to be disrupted in the future and they are much cheaper, like you said, than they have been in the past. If you are looking to reduce volatility, it's definitely something that you should take a look at as a potential core holding in your portfolio.

Benz: That seems especially appropriate for people who are approaching retirement and want to have a globally diversified portfolio but don't want the wild card of foreign currency changes breaking the wrong way on them.

Sotiroff: Right. Any person that wants to get a more steady stream of returns, I guess, is what we were calling it before. Anytime you can remove volatility from a portfolio, whether you are a retiree, or you depend on your portfolio now for more income that you did before, whatever your circumstances are, it's a great, easy, pretty mechanical way of eliminating volatility from a foreign stock investment.

Benz: Dan, really interesting research. Thank you so much for being here to share it with us.

Sotiroff: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.