Purer return and reduced volatility: Hedging currency risk in international-equity portfolios
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Exchange-Traded Funds
Exchange-traded funds | September 2014
Purer return and reduced volatility:
Hedging currency risk in international-equity portfolios
Currency-hedged exchange-traded funds (ETFs) offer investors a compelling way to access
international-equity markets and potentially achieve superior precision within portfolios. In our
view, currency-hedged ETFs remain an underutilized risk-management and portfolio-building
tool. Moreover, the case for hedging currency is particularly relevant in today’s environment,
when many investors are forecasting a stronger U.S. dollar.
Overview For U.S. investors, currency returns have largely enhanced
the performance of unhedged international equity
In addition to their low cost, tax efficiency, liquidity and investments over the past decade. This will not remain
transparency, ETFs have also delivered the benefits of the case indefinitely. As unhedged investors have found
market access and investment precision to investors. in recent years, a declining U.S. dollar will positively
Market segments that were once difficult to access, contribute to the returns of unhedged foreign-market
such as gold and China A-shares, are now available to a investments—but a soaring U.S. dollar will do the opposite,
broader investor base, thanks to ETFs. Additionally, today’s detracting from returns. Currency movements present an
investors are empowered to better control for unintended element of uncertainty for U.S. investors holding mutual
risks and achieve precise exposures within their portfolios funds and ETFs that invest in international equities.
by using increasingly sophisticated ETFs. Currency-hedged
ETFs, which allow investors to buy regional equities while In this white paper, we will explain the effect that exchange-
controlling for currency risk, are an excellent example rate movements have on the return of mutual funds and ETFs
of the intersection of access and precision. In our view, that hold foreign securities, discuss how exchange-rate risk
they remain underutilized risk-management and portfolio- can be mitigated through currency hedging, and describe
building tools—particularly in today’s environment, when why investors should view currencies within their portfolios
many investors are expecting a stronger U.S. dollar. as a contributor to both risk and return.
It’s no surprise that over the past decade, U.S. investors Contributors
have dramatically increased the proportion of their equity ——Dodd Kittsley, head of ETF strategy and national
allocations to exposures outside the United States. accounts, Deutsche Asset & Wealth Management
International equities now comprise more than 50% of ——Abby Woodham, ETF strategist, Deutsche Asset
the world’s equity market capitalization and contribute to & Wealth Management
roughly two thirds of the world’s gross domestic product
(GDP) growth.Exchange-traded funds | September 2014
What is currency risk? great news for American tourists in the Eurozone, but it’s
bad news for the investment. The €100,000 is exchanged
Foreign currencies are a significant, yet underestimated, for $100,000, meaning the investor realized a 33% loss
driver of risk and return in any international equity even though the share value remained unchanged.
investment—so much so, in fact, that we refer to this Figure 2 illustrates.
phenomenon as “currency risk.” Currency risk is the
possibility that the price of one currency will change relative Changes in exchange rates can and do significantly impact
to another over the course of an investment horizon, altering unhedged investments in international equities, and real-life
the return of a foreign-currency-denominated investment. examples of the currency effect abound. Toyota Motor Corp.
The buying and selling of domestic stocks takes place in U.S. returned 63.1% in 2013 for Japanese investors buying the
dollars, meaning domestic investors (or funds that invest in stock on the Tokyo exchange, but dollar-denominated U.S.
domestic equities) don’t need to exchange currencies during listing of Toyota returned only 33.4% because the U.S. dollar
these transactions. International stocks, on the other hand, strengthened against the yen in 2013. For a U.S.-based
are bought and sold in their own local currencies, meaning investor, more than 47% of the stock’s return was lost to
U.S. investors and U.S.-listed ETFs and mutual funds must changes in the exchange rate.
convert U.S. dollars to a local currency in order to make a
purchase. Then, when eventually selling, the ETF or mutual International investors who make unhedged investments
fund must exchange the proceeds, denominated in the local in U.S. equities suffer the same effect. The S&P 500 Index
currency, for U.S. dollars. If the exchange rate between the performed well in 2010, for example, returning 15.1%.
dollar and the local currency has changed since the purchase However, Japanese investors who bought an unhedged
date, however, the total return of the investment will be investment in the S&P 500 Index saw flat returns for the
impacted. Figure 1 illustrates. year because the yen strengthened considerably against
the dollar. Changes in the exchange rate between the U.S.
Figure 1: Domestic vs. international investments dollar and yen completely wiped out the equity return of the
Domestic investment Total return = equity return S&P 500 Index.
International investment Total return = e
quity return +/– currency return
This chart is for illustrative purposes only.
How currency hedging works
As an example of how currency risk works, consider an An international equity ETF or mutual fund can be fully
investor wants to buy $150,000 worth of shares of the exposed to currency returns, or it can mitigate currency risk
German company Bayer, which is a euro-denominated stock. through hedging. The objective of currency hedging is to
The exchange rate is $1.5 = €1, so the investor exchanges remove the effects of foreign-exchange movements, giving
$150,000 for €100,000 worth of Bayer shares. Over the U.S. investors a purer return that approximates the return of
course of the investment, the stock price doesn’t change, the local market.
and the investor decides to sell the shares for €100,000.
When it’s time to exchange the euro-denominated proceeds Within ETFs and mutual funds, currency hedging is typically
of the sale for U.S. dollars, however, the investor finds that accomplished through currency forward contracts, which
the exchange rate has changed to $1 = €1. This would be are agreements between two parties to buy or sell
Figure 2: How currency risk can hurt returns
$150,000 exchanged for €100,000 Stocks purchased with €100,000 €100,000 exchanged for $100,000
Exchange rate $1.5 = €1 Price unchanged over month Exchange rate $1 = €1
$150,000 €100,000
– €100,000
+ shares
$1.5 = €1 $1 = €1
$100,000 $100,000
This chart is for illustrative purposes only.
2 Purer return and reduced volatilityExchange-traded funds | September 2014
currencies in the future at an agreed-upon exchange rate. on a monthly basis, returned 53.0% for the year. Hedged
Currency forwards allow portfolio managers to protect their investors received returns that were more representative
investments from potential swings in exchange rates. In this of Japanese equity performance.
regard, currency forwards can be thought of as insurance
against a negative event.
To hedge or not to hedge?
Let’s return to our earlier example in which an investor
exchanges $150,000 to buy €100,000 of Bayer stock. Given that the returns from currencies can either add or
When it came time to sell, the investor lost money, not detract from the total returns of a foreign investment,
because the stock’s price has changed, but because the investor can either elect to hedge or not hedge currency risk.
exchange rate has gone to $1 = €1. Instead of realizing a
33% loss to the currency effect, the investor could have Investors with a view of the U.S. dollar relative to
hedged the investment by selling a currency forward foreign currencies should ensure that their foreign
contract that locked in the future exchange rate between market investments reflect their currency outlooks, either
U.S. dollars and euros. In other words, the investor would by being hedged or unhedged as the case may be. On a
make an agreement with another party to sell €100,000 total return basis, currency-hedged investments should
for $1.50 per euro, or $150,000, at a specified date in the outperform corresponding unhedged investments during
future (say, one month). At the end of the month, when the periods when the U.S. dollar is strong. Conversely, when
exchange rate had shifted to $1 = €1, the investor would sell the U.S. dollar weakens, currency-hedged investments
the shares for €100,000. Under the terms of the contract, the generally underperform.
investor would then sell that €100,000 to the counterparty for
$150,000. Because the investor locked in the exchange rate
Is your investment implicitly short the U.S. dollar?
at the beginning of the month, he or she received the same
flat return of a local investor instead of a loss.
Investments in equities, mutual funds and ETFs
denominated in another currency are implicitly “short”
Currency hedging helps investors avoid the distortion of the
the U.S. dollar: If the U.S. dollar strengthens over the
currency effect on their international investments, getting
course of the investment horizon, the foreign currency will
them closer to the returns that local investors receive.
be exchanged for fewer U.S. dollars at the time of sale.
For example, the yen-denominated MSCI Japan Index
However, today’s investors have the ability to control for
returned 54.6% in 2013; the U.S.-dollar-denominated version
this risk and can neutralize the impact of currencies in an
of the index returned 27.2%, thanks to the weakening yen.
efficient manner with currency-hedged ETFs.
The MSCI Japan 100% Hedged Index, which is hedged
Figure 3: Currency’s impact on return (in percentage points)
MSCI EAFE Index MSCI Japan Index MSCI ACWI
Return in Return in Currency Return in Return in Currency Return in Return in Currency
local U.S. dollars impact on local U.S. dollars impact on local U.S. dollars impact on
currency return currency return currency return
2004 12.7 20.2 7.5 10.8 15.9 5.1 13.1 20.9 7.8
2005 29.0 13.5 –15.5 44.6 25.5 –19.1 29.5 16.6 –12.9
2006 16.5 26.3 9.8 7.3 6.2 –1.1 18.1 26.7 8.6
2007 3.5 11.2 7.7 –10.2 –4.2 6.0 8.5 16.7 8.2
2008 –40.3 –43.4 –3.1 –42.6 –29.2 13.4 –40.9 –45.5 –4.6
2009 24.7 31.8 7.1 9.1 6.3 –2.8 31.7 41.4 9.7
2010 4.8 7.8 3.0 0.6 15.4 14.8 7.6 11.2 3.6
2011 –12.2 –12.1 0.1 –18.7 –14.3 4.4 –12.2 –13.7 –1.5
2012 17.3 17.3 0.0 21.6 8.2 –13.4 16.3 16.8 0.5
2013 26.9 22.8 –4.1 54.6 27.2 –27.4 20.1 15.3 –4.8
Source: Morningstar as of 9/1/14. Performance is historical and does not guarantee future results. Index returns do not reflect fees or expenses, and it is
not possible to invest directly in an index. See back page for index definitions.
Purer return and reduced volatility 3Exchange-traded funds | September 2014
Take, for example, an investor who believes the U.S. dollar period saw the MSCI Japan Index outperform the MSCI
may depreciate against foreign currencies. If this investor Japan 100% Hedged Index by an average of 7.5 percentage
is seeking to invest in international equities, an unhedged points. The trend reversed in 2012 as the Bank of Japan
ETF may be more suitable. If the investor’s assumption is initiated its aggressive quantitative-easing policy.
correct, he or she will receive the returns of the underlying The hedged index outperformed the unhedged index
securities as well as the gains of the local currency relative by 11.6 and 25.8 percentage points in 2012 and 2013,
to the U.S. dollar. On the other hand, hedged international respectively.
equity ETF may be the better solution for an investor who
believes the U.S. dollar will appreciate. If the investor’s view Another reason to consider hedging currency risk is that
proves accurate, he or she will receive the returns from over shorter periods of time, currency-hedged investments
the underlying securities while the negative impact of the have historically been meaningfully less volatile than their
stronger U.S. dollar is mitigated. unhedged counterparts. The reduction in volatility has been
significant to the point of providing potentially superior
Currency-hedged investments aren’t just for investors with risk-adjusted return.
an active view of future fluctuations in exchange rates.
The impact of currency on total return can be extreme Over the past 10 years through the second quarter of 2014,
and unpredictable. Investors without an opinion on future the five currency-hedged MSCI indexes shown in Figure 4
exchange rates may want to consider removing the currency (with the exception of Japan) averaged lower 12-month
component from their total return lest the equity return volatility than their unhedged counterparts. The reduction in
(and underpinning of their investment thesis) be swamped out. volatility also meaningfully boosted risk-adjusted return for
the hedged indexes relative to the unhedged. In the case of
As Figure 3 shows, currency’s impact on total return can be Japan, where the unhedged index exhibited less volatility,
extreme and unpredictable. From 2007 through September the hedged index did not suffer massive losses due to the
2012, the yen strengthened considerably against the strengthening dollar in 2013. As a result, the hedged index
U.S. dollar. During that period, the average 12-month also had a higher average Sharpe ratio, as shown in Figure 5.
Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14)
Hedged Unhedged
22.3% 22.4%
16.8% 18.3% 16.7% 17.0% 17.5%
14.9%
13.4% 13.3%
MSCI EAFE MSCI Japan MSCI Emerging MSCI Germany MSCI AC World
Index Index Markets Index Index Index Ex-USA
Source: Morningstar as of 6/30/14. Performance is historical and does not guarantee future results. Hedged indices are as follows: MSCI EAFE 100% Hedged
Index, MSCI Japan 100% Hedged Index, MSCI Emerging Markets 100% Hedged Index, MSCI Germany 100% Hedged Index, and MSCI ACWI ex-U.S. 100%
Hedged Index. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions.
Figure 5: Average rolling one-year Sharpe ratio over 10 years (7/1/04–6/30/14)
Hedged Unhedged
0.97
0.84 0.87 0.89
0.76 0.78 0.76 0.79
0.37
0.25
MSCI EAFE MSCI Japan MSCI Emerging MSCI Germany MSCI AC World
Index Index Markets Index Index Index Ex-USA
Source: Morningstar as of 6/30/14. Performance is historical and does not guarantee future results. Hedged indices are as follows: MSCI EAFE 100% Hedged
Index, MSCI Japan 100% Hedged Index, MSCI Emerging Markets 100% Hedged Index, MSCI Germany 100% Hedged Index, MSCI AC World Index Ex-U.S.
100% Hedged Index. Index returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions.
4 Purer return and reduced volatilityExchange-traded funds | September 2014
What drives currency moves? Conclusion
A widely followed economic theory, “purchasing power Despite growing to a $14 billion segment of the U.S. ETF
parity,” holds that there is an equilibrium real exchange rate market, currency-hedged ETFs remain a very small (less
between currencies over the long term. Currencies exhibit than 4%) segment of international equity ETFs. So why
mean reversion over time, and have a long-term expected aren’t more investors buying currency-hedged ETFs?
return of zero. This would imply that currency hedging isn’t We believe the primary cause has been the U.S. dollar’s
worthwhile. In reality, however, exchange rates can deviate deprecation over the past eight years, which has provided
substantially from this equilibrium rate, especially in the a tailwind to unhedged international equity portfolios.
short term. Risk without pain or consequence can often be tolerated
or forgotten by investors—until the environment shifts.
While many investors today may not have a holistic view Additionally, the ability to hedge through forwards and
of currency movements or a formal currency outlook, other derivatives was limited to the largest investors in the
they likely do have an opinion on some of the economic world until recently. Smaller investors were largely limited
factors that also drive currency values. Below are some key to unhedged investments. Currency-hedged ETFs are a
contributors to currency market movements. relatively new investment tool of which investors may not
be fully aware.
Monetary policy. When central banks raise interest rates,
the country’s bonds and other local assets appear more Today, investors are no longer forced to assume currency
attractive relative to other countries. The country’s currency risk as a natural byproduct of investing in international
will therefore appreciate as its assets are purchased by equities. With the advent of currency-hedged ETFs,
foreign investors. This effect can be particularly pronounced investors have fewer barriers to entry (such as scale and
in emerging market countries. cost) for the ability to tactically control currency-driven risk
and target currency-driven return potential.
Inflation expectations. If investors anticipate higher future
inflation, they generally expect the central banks to raise The impact of currencies and the decision to hedge
interest rates. this type of risk seems to be growing in importance as
investors’ appetite for international equities continues to
Balance of trade. If foreign demand for a country’s goods grow. Currency returns will likely continue to fluctuate
increases, the country’s currency will appreciate. Conversely, considerably and have a meaningful impact on investors’
if a country increases its import rates, all things being equal, realized returns. Investors in foreign equities can consider
that country’s currency will depreciate. hedging currency risk to receive “purer” return and
potentially reduce volatility.
Purer return and reduced volatility 5Definitions: One basis point equals 1/100 of a percentage point. China A-shares are shares of mainland-China-based companies that trade on Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange. Mean reversion is a theory that prices and returns eventually move back toward the mean, or average. The MSCI All Country World Index (ACWI) tracks the performance of 23 developed and 23 emerging markets; the MSCI AC World Index ex-US 100% Hedged Index is the currency-hedged version of the index. The MSCI EAFE Index tracks the performance of stocks in select developed markets outside of the United States; the MSCI EAFE 100% Hedged Index is the currency-hedged version of the index. The MSCI Emerging Markets Index tracks the performance of stocks in select emerging markets; the MSCI Emerging Markets 100% Hedged Index is the currency-hedged version of the index. The MSCI Germany Index tracks the performance of German stocks; the MSCI Germany 100% Hedged Index is the currency-hedged version of the index. The MSCI Japan Index tracks the performance of Japanese stocks; the MSCI Japan 100% Hedged Index is the currency-hedged version of the index. The S&P 500 Index tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. Shorting is borrowing then selling a security with the expectation that the security will fall in value. The security can then be purchased and the borrower repaid at a lower price. Standard deviation is often used to represent the volatility of an investment. It depicts how widely an investment’s returns vary from the investment’s average return over a certain period. The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of Deutsche Asset & Wealth Management, are as of September 2014 and may not come to pass. Investing involves risk, including possible loss of principal. Funds that invest in specific countries or geographic regions may be more volatile than investing in broadly diversified funds. Securities focusing on a single country may be more volatile. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable currency fluctuations, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There are additional risks because of potential fluctuations in currency and interest rates. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and increase volatility. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. © 2014 Deutsche Bank AG. All rights reserved. PM145862 (9/14) I-35854-1 RETAIL-PUBLIC CURRENCY-WHITE
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