Purer return and reduced volatility: Hedging currency risk in international-equity portfolios

 
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 volatility
Exchange-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    3
Exchange-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 volatility
Exchange-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   5
Definitions: 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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