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Going Global With a Hedge

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Going Global With a Hedge

With US equities continuing to swim near all-time highs this summer, many investors are seeking growth opportunities in other markets. The great news is that international equities offer a variety of benefits, including positive growth forecasts for 2018, highly attractive valuations, and a dividend yield that is currently as much as 50% higher than yields of many US equities.[1] With all those factors at play, it’s no wonder flows into non-US equities have continued to skyrocket.

However, as any experienced investor knows well, international equities also introduce a hazard that has the potential to thwart even the greatest investment opportunities: currency risk. Because the US dollar and the euro together comprise about 40% of the world’s Gross Domestic Product (GDP), the dollar-euro exchange has an enormous impact on global asset prices. At the same time, that exchange rate has demonstrated a highly uncomfortable level of volatility, fluctuating by about 20% a stunning eight times in the past decade alone. Combine that reality with other currency-related risks, such as the ever-changing economic fundamentals of foreign nations, inflation levels, interest rates, and central bank policy, and the potential for foreign exchange volatility is huge.

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One approach to help reduce currency volatility is to apply currency hedging to international holdings. And yet, even that isn’t a foolproof path to success. Because a strong US dollar can have a significant negative impact on returns of non-US equities, currency hedging can certainly help manage the potential risk of currency volatility and combat the impact of a rising dollar. On the flip side, that approach can have the opposite effect when the dollar falls—reducing portfolio returns, even if the actual value of foreign stocks in the portfolio has grown. Plus, even when a currency hedge is effective, investors who chase the performance of the dollar can fall victim to a whipsaw effect, experiencing huge hits to returns, due to highly unpredictable shifts in exchange rates.

The problem: Even investors who attempt to hedge against currency volatility typically react, rather than forecast. That is precisely why flows into hedged ETFs lag behind changes in exchange rates—and why investors often lose out on currency-based performance opportunities.

The solution: Research has shown that using a 50% currency hedge can help avoid that whipsaw effect by managing currency volatility and risk.[2] Not only can a 50% currency hedge help stabilize relative performance, but it may also help balance the unpredictable, and sometimes, dramatic swings in performance results between a 100% hedged or a 100% unhedged portfolio.

For a concrete example of how a 50% currency hedge can impact returns on non-US equities, just look at the numbers in July of 2017. In that one month alone, a sample portfolio of developed international equities would have delivered three dramatically different scenarios, depending on how it was hedged. A 100% unhedged approach would have delivered growth of +2.90%. Fully hedged, the same portfolio would have been up only +0.85%, costing the investor 205 bps, while a 50% hedged approach would have delivered a +1.88% jump in returns, partially protecting the fully hedged investor from the loss associated with the currency hedge.[3]

In the past, investors who understood the positive impact of a 50% currency hedge may have opted to achieve the balance of this optimal hedge by investing in two different international ETFs, including one that is 100% hedged and another that is 100% unhedged. The problem with this approach is that when (not if) foreign exchange volatility occurs, urgent rebalancing is required, resulting in costly transaction fees and potential capital gains taxes. It’s a less-than-ideal solution to a common challenge.

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Is there a better way? Absolutely. To streamline the process of gaining much-needed exposure to non-US equities and reduce the currency risk that comes with it, consider using a single smart beta ETF that includes international stocks from developed markets and hedges half of the currency exposure of those securities against the US dollar on a monthly basis.

By gaining this exposure through a single ETF, investors can “go global” by taking advantage of the potential growth, high valuations, and greater dividend yields of the international markets—all without the stress, costs, and risk of trying to chase the performance of the dollar.

To learn more about how a single ETF can make “going global” with a hedge easier than ever, check out our webinar.

Click here to learn more about IndexIQ.

Disclosure: The information and opinions herein are for general information use only. The opinions reflect those of the writers but not necessarily those of New York Life Investment Management LLC (NYLIM). NYLIM does not guarantee their accuracy or completeness, nor does New York Life Investment Management LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice.
1]Morningstar, as of 6/30/17.
[2] Whitelaw, Robert, PhD, Hedge of least regret: The benefits of managing international equity currency risk with a 50% hedging strategy, April 2017.
[3] The indices mentioned are the FTSE Developed ex North America Index, FTSE Developed ex NA 50% Hedged to USD, and the FTSE Developed ex NA 100% Hedged to USD. Past performance is no guarantee of future results, which will vary.  It is not possible to invest directly in an index.
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