Currency Hedging: 0%, 50%, 100% or Dynamically

Currency factor played a critical role in regards to the porfolio rate of return. Sometimes its impact exceeds the underlying asset itself. So it’s no wonder currency hedging concepts and related ETFs are so popular these years. Let’s take Japan equity as an example, in terms of the treatment towards currency exchange rate risk, there are at least 4 versions of ETFs (let’s put aside the difference of underlying indices): unhedged, 50% hedged, 100% hedged, and dynamically hedged. Naturally a string of questions arise: How should we look at currency exchange risk? Why currency heding ETFs are so popular in recent years? What kind of hedging strategy is the best?

1, Currency exchange rate risk is everywhere

I learned this from personal investment experiences. Currency is affecting our porfolio return from several ways:

– Commodity prices are affected by pricing currency. I invested GDX for a while, a gold miners ETF. As gold price are denomiated in U.S. dollars, the price of GDX is negatively correlated with U.S. dollar index.

– International equity prices are affected by the currency exchange rates. I invested EWP, a Spain ETF issued by iShares. I have double layer exposure to currency risks: I resides in Canada and Canadian dollar is my income tax reporting currency, so the CAD/USD matters to me; EWP is denominated in U.S. dollar but Spain uses Euro, so USD/EUR matters too. If tax implication (such as withholding tax) is considered ,this kind of investment is complicated for retail investors.

– Company’s income sources are affected by the currency exhange rates. I invested BEP.UN, a LP unit trated on the Toronto Exchange. In 2015 its unit price decreased sustantially, so I listened its conference calls. The company’s income come from several places: Canada, U.S., Europe, and Brasil. The sharp devaluation of Brasilian Real and the gloomy outlook of Euro dragged the valuation of BEP.UN. If you don’t look into the details of the company income’s geographical distribution, you won’t know why the share price changes.

So my personal takeway from thoese experiences and lessons are, always consider the currency factor your portfolio may have. Try to dig a few layers further to know how your holdings will be affected by currency factor. This is very important.

2, Preconditions of Currency Hedging ETFs

Currency hedging is a risk management tool. It is used with cost and have some preconditions:

– Currency pairs are free float and highly liquid. If a currency such as Chinese RMB Yuan is not free float, it is very difficult or expensive to adopt currency hedge strategies.

– Foreign currency’s interest rate is around zero. This will eliminate the interest rate difference factor and make the hedging simplified. Otherwise there is a delivery of interest rate difference between the two parties. If the foreighn currency’s interest rate is very high, such as India, the hedging gain cannot cover the interest rate difference, thus make the hedging infeasible.

So from the view angle of the U.S., we can see most of the currency hedging ETFs are invested in Japan, Europe.

3, Which hedging strategy is the best

Currency hedging is a very good example of product innovation in the ETF industry. Since 2006 WisdomTree launched the first currency hedging ETF, DXJ, the evolution of currency hedging is never stopped. In 2005, IQ index launched 50% hedged ETFs. In the beginning of 2016, WisdomTree launched dynamic hedging ETFs. Let’s take Japan as the example again, there are 4 different versions of Japan total market equity ETFs: unhedged EWJ (iShares), 50% hedged HFXJ (IQ Index), 100% hedged DXJ (WisdomTree), and dynamically hedged DDJP (WisedomTree).

Screen Shot 2016-02-09 at 3.55.58 PM

I’d like to use a simplified illustration to explain my understanding of those strategies.

Currency Hedging

We can see there are 4 strategies altogether. Among those 3 are static strategies and 1 is dynamic.

– Unhedged. This strategy means you are fully exposed to the exhange rate risk. You may suffer from the depreciation of the foreign currency you invested, while you may aslo benefit from the appreciation of the foreign currency. If you have no idea about the trend of the foreign currency exchange rate and are willing to take the risk, this is your choice.

– 50% hedged. You still have no idea with the exchange rate direction but want to do something. 50% hedging is like a straddle strategy in options. You pay a bit of cost to participate the exchange rate movements.

– 100% hedged. You don’t want to participate the game of currency movement. You just want to play the pure game of the underlying assets themself. 100% hedgeing strategy filtered the currency factor and make it a pure game. Or if you think the foreign currency will depreciate and you need the protection, this is your choice.

– dynamically hedged. WisdomTree uese a rule based method to decide how much should I hedged at any given time. The formula watchs three factors: interest rate, momentum, value, which are equally weighted. Under this method, the ratio of hedging could be any percentage between 0 to 100%. This is why it is called dynamic.

Debates about the effectiveness of currency hedging have never been stopped. It’s not easy to say which strategy is overwhelmingly superior than the rest. From the 4 ETFs chart above, we can see that due to recent appreciation of Japanese Yen, unhedged EWJ outperformed 50% hedged HFXJ and 100% hedged DXJ. With the direction of exchange rates become more and more difficult to predict, maybe the 50% or dynamic strategis are better choices. As those two funds are rolled out a very short period of time, we still need to watch for some time.

Abstract in Chinese / 中文摘要

在ETF领域,货币对冲是近年来的热门话题,包含货币对冲策略的ETF呈现爆发式增长,并在吸引资金方面表现抢眼。与此同时,货币对冲策略本身也在不断演进,令投资者面临多种选择。以投资日本的ETF为例,从货币对冲的角度看至少有4种类型的基金:(1)完全不采取任何对冲策略的,比如iShare的EWJ;(2)采取50%对冲策略的,比如IQ Index的HFXJ;(3)采用100%对冲策略的,比如WisdomTree的DXJ;(4)采用动态对冲策略的,比如WisdomTree的DDJP。1、3两种策略的基金较为普遍和成熟,3、4则是新近出现,3是去年6月上市,4则是今年1月才上市。这篇笔记写作之前花了较多时间进行文献阅读,对这几种策略进行了比较,试图从更宏观角度来理解和把握这4种策略的关系。

 

 

 

 

 

 

 

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