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Should I Take the Plunge Into Currency-Hedged ETFs?

Trying to time your portfolio's currency exposure could cost you money.

Question: I'm interested in getting international exposure, but I'm not interested in taking on currency risk. Is a currency-hedged ETF the way to go?

Answer: There are valid reasons to invest in either currency-hedged or unhedged foreign-stock funds. The danger comes in trying to predict periods of relative strength for the U.S. dollar, and buying and selling hedged and unhedged funds in response. For most long-term investors the best strategy is finding either a currency-hedged or unhedged fund with solid fundamentals, and sticking with it through thick and thin.

The Rise of Currency Hedged ETFs Assets flows into international funds have been strong over the past one-year period--particularly those into passive strategies. Especially acute has been investors' penchant for currency-hedged exchange-traded funds. (Click here to see senior markets research analyst Tim Strauts' video on the subject.)

In fact, as shown from this graphic from Morningstar Direct, assets invested in currency-hedged ETFs have exploded to more than $60 billion, with most of the growth occurring in the past six months. Two funds,

The Argument for Currency Hedging Investors' appetite for hedged foreign-currency products likely corresponds with the ascent of the U.S. dollar relative to major foreign currencies, as well as the frequent assertion that rising interest rates in the U.S. will stoke investors' appetite for dollar-denominated assets. Over the short term, the appreciation in the dollar has led to higher returns with lower volatility (as measured by standard deviation) for foreign-stock investors with hedged foreign-currency exposures. For example, the MSCI EAFE 100% Hedged to USD index (the index which DBEF tracks) has gained 11.2% over the past one-year period through June 30, while the MSCI EAFE has lost 4.2%. Comparing the standard deviations, the currency-hedged index has been less volatile at 8.41% over the past three years, versus 10.52% for the EAFE. As senior analyst Kevin McDevitt discussed in this article, foreign stocks actually had a terrific year in 2014, but appreciation in the dollar meant that U.S. investors in foreign-stock funds saw losses once the depreciation in foreign currencies was factored in.

Though this is a short-term trend, hedging currency exposure (so that the fund’s return reflects changes in security prices--rather than changes in the value of various currencies relative to the dollar) can be a valid long-term fundamental position. In fact, Tweedy, Browne, a fund shop that has been investing in non-U.S. stocks since 1983 and has managed

In a recent white paper entitled "How Hedging Can Substantially Reduce Foreign Stock Currency Risk", they outline their hedging philosophy: "At Tweedy, Browne, we pick stocks; we do not pretend to understand currency valuations. We can read a company's balance sheet, but we cannot read a country's balance sheet. We count our wealth in U.S. dollars, and seek to avoid losses from non-U.S. currencies. As a result, in the Tweedy, Browne Global Value Fund and the Tweedy, Browne Value Fund, we have chosen to hedge the Funds' perceived foreign currency exposure back into the U.S. dollar."

But, importantly, Tweedy, Browne does this consistently--not just when they have a positive outlook for the U.S. dollar versus other currencies. In fact, there have been times in the not-too-distant past (such as 2005-07) when the fund lagged its category rivals, partially due to the U.S. dollar’s weakness relative to currencies such as the pound and the euro.

The Case for Not Hedging Which brings us to the other side of the argument on currency hedging: Many investors believe that exposure to foreign currency in a portfolio is an additional, and beneficial, level of portfolio diversification. (See the GMO white paper, "The Case for Not Currency Hedging Foreign Equity Investments: A U.S. Investor's Perspective", which states that GMO typically hedges currency exposure for fixed-income investments, but not for equity investments. The paper attempts to debunk the perception that currency hedging reduces portfolio risk over longer time horizons, and makes the argument that hedging introduces leverage, which can actually lead to higher tail risk.)

Senior analyst Patricia Oey points out in her recent analyst report of DBEF that during certain periods, a long exposure to foreign currencies can add to performance. "In the seven years through December 2007, a falling U.S. dollar provided a boost to foreign equity funds. Over that time period, the unhedged MSCI EAFE Index outperformed the MSCI EAFE 100% Hedged to USD Index by 400 basis points, annualized."

Over Longer Periods, It May Not Matter The dollar has been strong lately: The greenback has risen more than 20% versus the euro and over 10% versus the pound over the past one-year period ended July 10. Although it's impossible to say that the dollar's strength is "tapped out," it's equally difficult to say that it will continue unabated. The point is, currency movements are notoriously difficult to time correctly, even for professional investors (as Tweedy, Browne points out). But the good news is, over longer time periods, risk-adjusted annual returns on hedged foreign stock portfolios have been similar to the returns on unhedged foreign stock portfolios.

In a recent research paper excepted in this article, senior analyst Patricia Oey said: "We found there is no significant difference in long-term risk-adjusted returns between portfolios that use a currency-hedged international-equity strategy and portfolios that use an unhedged international-equity strategy. As such, long-term investors should focus on choosing well-run, low-cost international-equity funds for their portfolios and should be indifferent to whether or not the funds hedge their currency exposure."

All other things equal*, the important thing to consider, then, is that the investments you pick are solid from a fundamental standpoint. Jumping into a strong-performing (and often, therefore, hot-selling) asset class often ends up costing investors money because they buy in after a runup and sell after a period of poor performance. This is especially true when trying to time something as unpredictable as currency movements. As Morningstar head of global manager research Jeffrey Ptak recently wrote, "tempting as it might seem to try to manicure our portfolio's currency exposures to achieve a particular end, we'd probably be better off asking more fundamental questions about what our goals are and whether we've structured our portfolios accordingly."

Further Considerations *Here's where all other things may not be equal: It should be noted that the appropriateness of a hedged strategy tends to vary with investment type and life stage. For investors in bonds who have short or even intermediate time horizons, for example, hedged strategies are often considered more appropriate than unhedged ones. The reason is that unhedged bond strategies tend to be much more volatile than hedged ones; a shorter-term investor would simply not have much time to recover from a bad foreign-currency swing in her bond fund.

In a similar vein, the investment team at Morningstar Ibbotson Associates has argued that investors should taper foreign-currency exposure in their equity and bond portfolios as their time horizons decline; here again, the possibility of a negative foreign-currency swing is a greater risk than the diversification that accompanies foreign-currency exposure is a benefit. (For more on this, see the Ibbotson Associates research paper "Lifetime Asset Allocations: Methodologies for Target Maturity Funds".)

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