Using inexpensive passive strategies for international equity exposure has gained plenty of traction as the popularity of ETFs has grown across the board. There are still plenty of active managers worth the added expense, but like many other asset classes, there are times when an active approach is in favor relative to a passive benchmark, and vice versa.
Similar to the decision between active vs. passive, the choice also exists for investors within passive strategies to include or remove exposures to the foreign currencies through unhedged and hedged strategies, respectively. While choosing the lowest cost option may feel like the “most passive” solution, investors should take note that choosing a strategy that does not hedge foreign currencies is essentially making an active decision to partake in the returns of the foreign currency vs. the domestic currency (USD). This can significantly increase the volatility of a foreign equity investment and can potentially result in negative total returns even when the portfolio of local equities rises in value.
In that case, why not remove the currency exposure all together? Doing this may harm the investor in the opposite situation where the portfolio of local equities falls in value and is offset by an appreciation in the currencies, bringing the total return to a positive number. Or, currency movements can compound a loss on top of an equity loss.
Whether an investor chooses not to hedge currencies or to fully hedge currencies, they are making a currency bet one way or another.
Timing currencies is a losing game
There is no lack of opinion on the direction of currencies for many reasons, a few of them being economic pressures, central bank views, and geopolitical concerns. Unfortunately, for every opinion on strength, an opinion on weakness is so close you can often find it in the same article!
While companies can theoretically grow indefinitely, the strength of one currency compared to another historically mean reverts, or gravitates back to an average. Therefore, deciding whether to have currency exposure or not based on past performance is, in our view, likely the worst thing an investor can do. And in practice, it’s often very difficult to tactically and efficiently manage currency exposure within an investor’s portfolio.
Case in point: Figure 1 shows the rolling 3-month advantage that currency hedging provides on an international index, along with the monthly net flows of money into and out of currency hedged ETFs. It seems that after hedged outperforms unhedged, the money chases the relative outperformance only to suffer a relative underperformance, and vice versa.
Figure 1: Flows in currency hedged ETFs tend to be poorly timed, often coming in after significant outperformance and going out prior to stronger performance vs. unhedged ETFs.
Monthly flows chasing 3-month Index performance
Source: Morningstar, 3/1/14-12/1/19 Past performance is not indicative of future results. An investment cannot be made in an index. Flows are represented on the right axis in $Billions, and include the cumulative monthly net flows of all existing Foreign Large Blend Passive Currency Hedged Index ETFs that existed at the time. The 3 Month Hedged Advantage refers to the relative 3 month trailing rolling performance of the MSCI EAFE Currency Hedged Net Return USD Index to the MSCI EAFE Net Return USD Index (Unhedged).
In fact, during this same time period, an investor’s annualized return in currency hedged international ETFs adjusted for net flows was -0.21%, while the MSCI EAFE 100% Hedged Index returned +6.13. In other words, going in and out of the hedged product cost investors 6.34% annually because of mistiming currency moves.
So, how can investors avoid the guessing game of currency movements but still reap the benefits of hedging? One option to consider is a truly passive 50% currency hedge. With this approach, timing the relative position of currencies to each other is unnecessary as the investor can potentially participate in foreign currency appreciation and manage downside exposure to the same extent. This passive buy and hold approach also can be more tax efficient compared to transacting between a hedged and unhedged fund (or rebalancing a pair) each containing the same underlying equities.
Below is a visual representation of how often the shift between hedged and unhedged foreign equity exposure can vary:Figure 2: Rolling 6 month relative performance of Fully Hedged and Unhedged MSCI EAFE Index returns relative to the FTSE Developed ex North America 50% Hedged Index.
Hedged and unhedged relative to 50% hedged
Source: MSCI, FTSE, IndexIQ, 6/1/2005 – 12/1/2019. Past performance is not indicative of future results. An investment cannot be made in an index.