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The case for employing embedded currency hedging in ETFs

A transparent hedging strategy can reduce currency risk and optimize portfolio return. That’s the view of Andrew Walsh, Head of Passive & ETF Specialist Sales – UK and Ireland at UBS Asset Management

Investors in international equity ETFs are exposed to two main risks: the direction of the equity market in which they have chosen to invest; and the foreign currency exposure that is often a byproduct of an equity bet, but which has the potential to derail returns. Without any currency hedging in place at all, investors are taking an implicit bet on the foreign currency strengthening, which may or may not be consistent with their macroeconomic view.

It is a generally accepted view that currency risks exist primarily in the short to medium term, but less so in the longer term. That is to say, over the long term currency movements do not tend to add or subtract from investment returns as they usually average themselves out. In the short run, currency movements can be quite dramatic and can have a major impact on the returns of the underlying investment.

The impact of currency movements on returns

To illustrate the extent to which currency movements can impact returns, one can go back five years to the Japanese market. A local Japanese investor holding the Nikkei 225 from 1st January 2012 to 30th June 2013 would have achieved a 66.9% return in Yen terms, while a US investor through that same period would have experienced considerably less impressive returns of 29.3% due to the steep depreciation of the Yen through that period.
(Source: Bloomberg)

Of course predicting currency movements is notoriously difficult and with concerns about currency volatility increasingly on investors’ minds, many want to neutralise this uncertainty on investment returns so as to access the underlying investment as cleanly as possible. The use of hedging Currency hedging could be compared to buying insurance. Simply, when an investor buys a fund with a currency hedge embedded in the product, they are trying to protect themselves from potential losses which would occur if the underlying currency of that foreign exposed fund (e.g., JPY, CAD, USD) were to decline against the GBP while the UK-based investor held the fund.

Predicting currency movements is notoriously difficult, and with concerns about currency volatility increasingly on investors’ minds, many want to neutralise this uncertainty on investment returns so as to access the underlying investment as cleanly as possible

Large institutions have little difficulty in accessing the foreign exchange market and thus can chose to implement currency hedging overlays across their entire portfolio. Unfortunately, this is not often possible for some mid-sized and the great majority of smaller investors in part due to a lack of solutions on offer to them. Thus, there has been an increasing demand from UK and foreign investors alike to access key international equity markets with currency hedging built into funds such as ETFs.

An important aspect to consider when looking at currency hedged products is whether they follow daily or monthly hedging. From a conceptual point of view, monthly hedging features a less ‘perfect’ currency hedge compared to daily hedging. Implicit in monthly hedging is a higher risk of under- and/or over-hedging because of the longer time period between the nominal adjustments of the hedge. However, in practice, a higher frequency of hedge adjustments results in higher trading costs due to more transactions i) for adjustments of the hedging derivatives and ii) for investments and divestments of hedging profits and/or losses, respectively.

In brief, daily hedged products on plain vanilla benchmarks tend to track their respective index more accurately (when not considering trading costs of the underlyings). However, in practice, when taking the trading costs into account, products using monthly currencyhedging benchmarks can more accurately track the index due to significantly lower trading costs. This is the reason why the ETF industry leaders tend to set up their physically-replicated UCITS ETFs on monthly hedged benchmarks. Furthermore, as currency hedging has also become an important feature for passively-managed portfolios, a key criterion for index providers is to establish a methodology which allows replication of hedged benchmarks as closely as possible. Hence, it is not only relevant at which point in time a profit is reinvested, but also the timing of putting in place a new currency forward agreement. We expect index providers to continue to improve their currency hedged methodologies to account for these points. This will ensure excellent tracking quality of the products, while minimizing tracking error compared to the underlying benchmark.

Another good example of a case for currency hedging slightly closer to home is that of the Eurozone equities market over the 2yr period between May 2013 – May 2015 (see chart 1). Through this period, the MSCI European Monetary Union (EMU) index delivered +19.6% annualized returns for a EUR investor. However, a UK-based investor buying the same index (without any GBP-hedging) would have experienced an annualized return of just +11.7% due to the negative impact of the decreasing value of the Euro against Sterling during this period. If the UK-based investor had instead opted for the MSCI EMU GBP-hedged index through that period, their returns would have been almost identical to the Eurozone investor at +19.9% per annum (in this case, slightly better performance than the unhedged local currency returns due to the way the monthly hedging panned out through this period).

Currency hedging in fixed income

While there is far more prevalence for using embedded currency hedging in equity ETFs, it is in fact arguably, an even more important consideration when investing in foreign fixed income. This is due to the fact that currency movements can, in many cases, easily outweigh returns from both a bond’s coupon and price returns. This means that an investor’s returns in foreign fixed income are sometimes totally at the mercy of these currency fluctuations. Chart 2 shows the example of the Bloomberg Barclays US Liquid Corporates index return makeup in USD (see chart 2 – simply price return and coupon) for a local US investor. Chart 3 shows this index for a UK-based investor who must bear the currency swings of sterling vs the dollar while investing in this index. As is clear from the red bars, the UK investor’s returns overall are more often than not dictated by fluctuations in the GBP/USD rate, not the price return and coupon. An investor choosing this index (and an ETF tracking that index) with embedded GBP-hedging would be able to neutralise that impact and participate in this exposure just like a domestic US investor.

Ultimately, investors will have an increasing choice of funds which offer currency hedging – particularly with ETFs. Where investors want exposure to a particular country or region’s equity or bond market without the risk of having to take any specific conviction on the direction of the currency, a currency hedged ETF offers very easy and cost-efficient access to international market indices.

Finally, investors should be aware that if a fund has a GBP listing, that does not make it GBP-hedged. Only a product which is actually currency-hedged can protect an investor from a declining foreign investment currency. An important caveat for investors to be aware of is that currencyhedging is a double-edged sword. That is to say, if a foreign currenc
appreciates against Sterling whilst you are invested in a GBP-hedged product, you will forego the gains that that appreciation would have delivered. Thus, for investors who feel that that the currency of a specific country (Japan) or region (Eurozone) is likely to rise in future would typically want to avoid buying a fund exposed to them with embedded GBP-hedging.

UBS Asset Management is Europe’s 4th largest ETF provider with GBP 39.8bn in AUMs and is a one of the leading providers of currency-hedged ETFs in the region. UBS has a wide range of ETFs available for UK investors with 95 LSE listings across key asset classes.

Andrew Walsh is Head of UBS Passive & ETFs Specialist sales for UK & Ireland and is responsible for developing and implementing the UBS ETF business in the UK. Andrew joined UBS Asset Management in November 2012 and has 24 years of investment experience having worked at Societe Generale and HSBC prior to joining UBS. Andrew holds the Investment Management Certificate (IMC).

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