To Hedge or Not to Hedge?

International Investing is the New Normal

Investors all over the world are continuing to see the potential benefits of investing beyond their home base. Economic performance at home may be sputtering, leading to flat local stock market returns. But somewhere else, perhaps on the other side of the globe, economies may be humming along and producing attractive stock market gains.

Ten years ago it was the exception to see an investor devote a significant portion of their portfolio to international investments. Now, it’s not unusual to see investors allocating 20% to 30% or more to global investments. And the opportunities to invest internationally have become easier than ever to access through country- and region-specific ETFs. If you think Asia is going to be a major source of growth in the decades to come, for instance, investors can easily buy an Asia-regional stock ETF composed of the leading companies throughout Asia.

Understanding Currency Risk

When investors go global and invest outside of their home market, they’re typically exposing themselves to currency risk—the risk that the value of their investment will be negatively affected by changes in currency values.

On the flip side, changes in currency values can also improve an investment’s returns. Reversing the scenario above, a European investor (EUR-based) who bought a US stock index ETF that holds shares denominated in USD would have seen returns improved due to gains in the USD relative to the EUR.

In both of the examples above, the investors were exposed to currency risk because their investments were not hedged against changes in currency values. For investors looking to minimize or eliminate currency risk in their international investments, an increasing number of global ETFs are now available that offer currency hedging. You can identify which ETFs are hedged because they’ll usually have the phrase ‘currency hedged’ in their name. If it doesn’t say ‘currency hedged,’ it likely isn’t and carries exposure to the currencies of the countries it invests in. A quick reading of the prospectus or fact sheet for an ETF will also make it clear whether it hedges currency exposure.

Most are USD-denominated ETFs, which means that investors will still face currency exposure if the USD is not their home currency. An Indonesian investor who wants to invest in Japanese stocks, for example, could invest in a USD-based currency hedged ETF of Japanese stocks. The investment would be hedged against changes in the value of the Japanese yen (JPY) against the USD, but the investor would still be exposed to changes in the value of the USD against her home currency, the Indonesian rupiah (IDR).

Taking a View on Currencies

We’ve already seen how currency moves can help and hurt international investments. For investors to decide whether to use hedged or unhedged ETFs for their global investing, they need to get a sense of where the major currencies may be heading.

While the currency market may seem complicated at first, it helps to know that changes in interest rates are typically the most important driver of currency values. Remember that when looking at currency values, you’re always looking at how one currency compares to another. That means looking at two different countries’ interest rates as well, to get an idea of how the currencies’ values may change relative to each other.

Generally speaking, a country that is raising interest rates (or is expected to) relative to other countries will see its currency tend to strengthen against other currencies. A country that is lowering interest rates (or is expected to) will tend to see its currency weaken against other currencies. Some of the biggest changes in currency values occur when one country is raising rates vs. another country that is lowering interest rates.

A good example is recent US dollar strength against most of the world’s major currencies over the last year. The US central bank, the Federal Reserve, has been seen to be preparing to raise interest rates in the near future, while central banks elsewhere have been cutting interest rates and indicating that rates would remain low for the foreseeable future.

Investors can get a very good idea of where interest rates are going by paying attention to what the major central banks suggest in their policy statements, which are always well publicized. Depending on the circumstances, an investor might want to use an un-hedged investment if the value of the currency of the investment is expected to strengthen relative to the investor’s home currency. If the investor’s home currency is expected to gain against the currency of the investment, then a currency hedged investment might be the way to go. And investors can easily switch between hedged and un-hedged ETF investments.