Currencies that just won’t stay still are causing havoc for investors who ventured to buy foreign stocks and bonds.
It’s not a new problem, but over the past few years there has been a surge in products designed to eliminate that risk — so-called currency-hedged exchange-traded funds.
But should you consider them as part of your portfolio?
“The change in currency prices explains a significant amount of the volatility when investing in international funds,” says Bob Stammers, director of investor education at the CFA Institute in New York.
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Currencies have made big moves recently. Last year, the U.S. dollar appreciated against its major trading partners, with the dollar index rising by around 10 percent, according to the Federal Reserve Bank of St. Louis. If nothing else happened to foreign investments — that is, if the stock prices overseas didn’t move — the dollar value of overseas holdings of U.S. investors would have fallen last year.
This year, the U.S. currency has gone the other way, down around 5 percent.
“By hedging the currency risk, the volatility from currency changes is removed so that the investor is only exposed to the businesses that they invest in,” Stammers says. “This is even more important when investing in international securities that provide a significant amount of investment returns in the form of dividends.”
Those dividends get repatriated and converted back into dollars for U.S. investors. In the case of a stronger dollar, that means smaller cash dividends.
That would seem like a good reason to want to hedge the currency movements away. But it’s probably better for most small investors to not bother with such funds. For long-term investors, unhedged funds don’t do any better than hedged funds.
Watch the fees. “Some currency-hedged ETFs are more expensive than the non-hedged ones,” says Jay Jacobs, director of research at Global X. Plus, there could be unfavorable tax issues for funds that use futures contracts to hedge the risks.
Gains from trading futures contracts have different tax rules than other investments in the U.S.
Even small differences in annual fees and differences in how the gains are taxed can have outsized impact when holding such funds for a long period.
Even more volatility in your portfolio? Jacobs says some currency hedged funds could leave you with more volatility in your portfolio depending on which country they are invested in.
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“Japan is one place where we believe that there is case for not having currency-hedged portfolios,” he says. That country has a negative correlation between the stock market and the value of the Japanese yen. As the yen appreciates, the stock market typically falls.
So when the yen rallied recently, investors in hedged funds were left with a downward move in the value of their stock holdings and no offsetting currency move.
On the other hand, the stock market and currency usually moves in tandem in Norway, Jacobs says.
Tactical investors who can anticipate moves in the currencies can benefit from using such products. But anticipating currency markets is tricky at best. If you get it right though, the gains can be huge. If you get it wrong, your losses can be painful.
“We don’t recommend timing the hedge versus unhedged because most people can’t time the markets correctly,” says Patricia Oey, a senior analyst at Morningstar.
And although hedging currencies of the major developed economies of the world is relatively inexpensive and simple, that is not the case for all countries.
“When you talk emerging market currencies, then most people won’t hedge,” Oey says. “They either can’t be hedged or doing so is too expensive.” Venezuela would be an example of a country where hedging the currency would likely be a problem.
If you still want to invest in such products where do you look?
Look at the big funds. Some of the biggest currency hedged funds include the WisdomTree Europe Hedged Equity ETF (ticker: HEDJ) which has annual expenses of 0.58 percentage points, or $58 per $10,000 invested; the Deutsche X-trackers MSCI EAFE Hedged Equity (DBEF), with an expense ratio of 0.35 percent; and the WisdomTree Japan Hedged Equity (DXJ) with an expense ratio of 0.48 percent.
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Bigger funds tend to have more liquidity and hence lower bid-ask spreads, meaning that it’s less expensive for investors to buy or sell their positions than when trading in less liquid securities.
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What You Need to Know About Investing in Currency-Hedged ETFs originally appeared on usnews.com
