Hedge Against Exchange Rate Risk with Currency ETFs

Investments in overseas stocks and bonds can earn a better return and add valuable diversification to a portfolio, but they bring along the extra risk of exchange rates. Given the potential for foreign exchange rates to distort portfolio returns they should be hedged where appropriate.

Once upon a time, to make a profit or simply hedge against movements in different currencies, you would have to trade currency futures, forwards or options, open a forex account, or buy the currency itself. The relative complexity of these strategies meant they did not catch on with the average investor. The benefit of currency exchange-traded funds (or ETFs) is that they are a natural hedge for individuals who want to protect their portfolio from exchange rate movements.

This makes currency ETFs a simple, highly liquid way to benefit from a currency’s moves, without the fuss of opening a futures account or trading currencies on the foreign exchange (forex) market: You buy them like any ETF, in your brokerage account (including an IRA or 401(k) account).

Why Currencies Move

Foreign exchange rates are the numbers that underlie cross-border transactions – they’re simply the price at which one of those currencies can be redeemed for another. As the value of each currency fluctuates against another, the price of exchange will rise or fall.

Factors that can impact on a currency’s value include economic growth, the government’s debt levels, the size of trade, oil and gold prices among many others. The USD, starting to depreciate in late 2013, fell against other currencies in 2014 when the pace of gross domestic product (GDP) growth slowed, when government debt rose as did the size of the whopping trade deficit. Rising oil prices, for example, tends to increase the levels of currency for net oil or oil reserve-rich countries, such as Canada.

A more extreme example of a trade deficit would be that country takes in far more than it sends out. You have too many importers flooding their own currencies into the market to bid up the currencies of the countries whose goods they want to buy, and the currencies of those importers’ countries lose value due to excess supply.

Impact of Exchange Rates on Currency Returns

Consider how currency exchange rates affected the returns to investment in that same period. Let’s return to that challenging first decade of the new millennium. US investors choosing to restrict their portfolios to large-cap US stocks saw the value of their holdings lose an average of more than one-third. Over nearly nine and a half years from January 2000 to May 2009, the S&P 500 Index lost nearly 40 per cent. The total return from the S&P 500 including dividends over this period was about -26 per cent or -3.2 per cent per year on average.

Canadian equity markets, the largest trading partner of the US, did much better over this period. Underpinned by surging commodity prices and a strong economy, the S&P/TSX Composite Index gained about 23% – with dividends included, total return was 49.7% or 4.4% annually; therefore, the Canadian S&P/TSX Composite Index beat the S&P 500 by an astonishing 75.7% cumulatively or about 7.5% annually.

While U.S. investors who were in the Canadian market over this period also did better than their stay-at-home US counterparts, whose portfolios were limited to domestic-only investments – historic punishment for dollar-centric blinders– the additional turbo lifted by the loonie’s 33% appreciation against the greenback really pumped up returns for the US investors. On a US dollar basis, the S&P/TSX Composite was up 63.2% and, including dividends, it rallied an extraordinary 98.3% or 7.5% annually. That’s an outperformance versus the S&P 500 by 124.3% cumulatively or 10.7% annually.

This translated into the fact that $10,000 invested by a US investor in the S P 500 in January 2000 would, by the time it got to May 2009, have been reduced to $7,400, whereas $10,000 invested by a US investor in the S P/TSX Composite over the same period would have grown to $19,830.

When to Consider Hedging

The dollar subsequently started an extended (long-term/secular) downward trend, for which global US investors who had invested offshore during the first 10 years of the 21st century benefitted greatly as they held assets in an appreciating (foreign) currency. Holding assets in an appreciating (foreign) currency therewith became an unmitigated boon for the US investor. Also hedging exchange risk was an unwelcome proposition here, at least during much of this time period.

But, a lower currency can caution you to reconsider any positive returns recorded in your investment portfolio, or worsen the negative returns captured in your return data.For instance, let’s consider those Canadian investors who were invested in the S P 500 from January of 2000 to May of 2009. If all they had paid attention to was the average annual return over that period — -44.1 per cent in Canadian dollar terms (compared with returns of -26 per cent in US dollar terms for an investment in the S P 500 alone) — they were really holding investments in an asset class in a depreciating currency (the US dollar in this case) and their performance was much more affected by this currency fluctuation than the index results for those who were not using their own currency to measure their returns.

For example, during the second half of 2008 the returns to the S&P/TSX Composite were 38 per cent; that’s one of the worst years for equity markets in the world over that period, thanks to falling commodity prices, coupled with a global sell-off in all assets. The Canadian dollar fell almost 20 per cent against the US dollar over the same period. If a US investor invested in the Canadian market during this period, she would, in round numbers, have had 58 per cent total returns (ie, excluding dividends, just to keep it simple) for the six months.

In this instance, an investor who wished to invest in Canadian equities but seek to minimise exchange risk might have accomplished this through currency ETFs.

Currency ETFs

Through currency exchange-traded funds (ETFs), holders can invest in foreign currencies in the same way they would in equities or fixed-income securities. The return of one of those instruments is linked to the movements of the currency in the exchange market by either maintaining a currency-cash deposit in the currency being tracked or by relying on a futures contract on the underlying currency.

Either way, these instruments should produce a return strongly correlated to the actual movement of the currency over time. This type of fund usually has very low management fees, as they are not very active funds, but always check your fees before you buy; it’s always better to be safe than sorry.

And, since there are many currencies ETFs in the marketplace, you can buy funds that move in line with individual currencies. The CurrencyShares Swiss Franc Trust (nyse:FXF), for instance, tracks the Swiss franc. A naïve investor might decide to buy the ETF if he believes that the Swiss franc is about to gain value against the US dollar, perhaps by expecting stabilisation in the euro zone to prompt Swiss firms into investing in overseas expansion. Intriguingly, a short sell on the ETF could be placed if he believed the Swiss currency was about to plummet.

You can also buy ETFs that track a basket of currencies. Invesco DB U.S. Dollar Index Bullish ETF (UUP) and Bearish (UDN) funds track the U.S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. If you believe the U.S. dollar will fall broadly across the board, buy the Invesco DB U.S. Dollar Index Bearish ETF.

Still more active currency strategies can be found in currency ETFs such as the DB G10 Currency Harvest Fund (DBV), which seeks to track the Deutsche Bank G10 Currency Future Harvest Index that does what it says. The basis trade which, in this case, buys futures on the currency in the G10 with the highest yield to pick up the widest yield spread, and simultaneously sells futures on the three G10 currencies with the lowest yields.

Broadly speaking, then, just like other ETFs, if you sell an ETF and its foreign currency has risen against the dollar, you will make a profit. And if you sell it when its currency or underlying index has gone down against the dollar, you’ll be losing money.

Hedging Using Currency ETFs

For instance, let’s look at say an American investor who put $10,000 into Canadian stocks through the ETF iShares MSCI Canada Index Fund (EWC). The fund attempts to track the performance of the broad Canadian equity market by providing investment results that correspond to the price and yield performance of the Canadian equity market, as represented by the index. At the end of June 2008, the ETF shares traded at $33.16, so the investor with $10,000 would have bought 301.5 shares (after paying the merchant the brokerage fees and commissions).

This investor also would have shorted shares of the CurrencyShares Canadian Dollar Trust (FXC), which tracks the price of the Canadian dollar in US dollars. When the Canadian dollar increases in value against the US dollar, the FXC shares move up, while if the Canadian dollar depreciates against the US dollar, the price of these FXC shares moves lower.

Remember that, if the investor believed the Canadian dollar would strengthen, they would have chosen to forgo hedging the exchange risk or, better yet, ‘double up’ on the Canadian dollar exposure by buying (or ‘going long’) units of the FXC shares. Since we were, instead, assuming the investor wanted to hedge against exchange risk, then they should have sold short the FXC units.

Specifically, with the Canadian dollar trading near parity with the US dollar at the time, let’s say the FXC stock traded hands at $100/share, so the investor would assume a short position of 100 FXC shares to hedge the $10,000 worth of EWC stock. If the FXC shares traded lower, as hoped, he would buy the shares back and realise his gain on the hedge reservation in the portfolio.

By the end of 2008, the EWC shares had fallen to $17.43, a drop of 47.4 per cent from the buy price. Some of the EWC share-price decline would have resulted from the Canadian dollar falling against the US dollar during this period. Any such FX loss would have been offset by gain from the short FXC position. At the end of 2008, those FXC shares had dropped to about $82 so the gain on the short would have been effectively $1,800.

The unhedged investor lost $4,743 on the original investment of $10,000 in shares of EWC. The hedged investor’s portfolio would have had an overall loss of $2,943.

Margin-Eligible

From a cost-benefit perspective, some investors might regard the cost of investing a dollar to hedge each dollar of overseas investment as too high for their taste. The hurdle posed by the cost factor in currency hedging can be bypassed, since unlike most regular mutual funds and ETFs, which are non-marginable, currency ETFs are margin-eligible. Accordingly, both the overseas investment, which includes foreign stocks, and the currency ETF can be purchased with a margin account, which is a brokerage account where the broker lends the client a fraction of the needed amount to make the purchase.

This allows a fixed-amount investor to both make the investment and hedge exchange risk; to do so, 50 per cent could be invested with a margin of 50 per cent, and the remaining 50 per cent of the fixed investment amount could be used for a position in the currency ETF. In making investments on margin, you are effectively using leverage. Leveraged investment strategies involve additional risks and investors should understand these risks before making the investments.

The Bottom Line

Currency moves are unpredictable, and currency volatility hurts portfolio returns. For instance, despite the unprecedented credit crisis in the first quarter of 2009, the US dollar unexpectedly surged against all the major currencies during that time, exacerbating negative returns on foreign assets for investors in the US.

Hedging exchange risk becomes especially relevant during times of unusual local currency volatility.Given all these investor-friendly features, currency ETFs provide great hedging potential for retail investors, allowing them to mitigate exchange risk effectively. (For more about exchange rate volatility, see “How to Avoid Exchange Rate Risk” on the next page.)