FX: Mixed outlook for currency hedged ETFs

By:
Paul Golden
Published on:

Demand for currency hedged exchange-traded funds (ETFs) is expected to remain strong this year thanks to FX volatility, but year-on-year growth pins on the dollar.

For unhedged investors, 2015 saw FX volatility savaging returns on a slew of assets – particularly in emerging markets – offsetting capital appreciation and coupon income, and fundamentally altering their risk-return profile.

As a result, demand for currency hedged passive exposure to foreign assets rose dramatically, with net inflows into currency hedged exchange-traded products (ETPs) in Europe totalling almost $4 billion and assets under management growing year-on-year by 28%, according to Deutsche Bank research.

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Ben Seager-Scott,
Tilney Bestinvest

Central-bank activity has driven significant movements in developed-market currencies in a way that simply hasn’t been the case for a number of years, observes Ben Seager-Scott, director of investment strategy at Tilney Bestinvest.


"The second, more enduring source of demand for currency hedging is likely to be in areas such as high-quality fixed income," he says. "There is generally a preference to have these asset classes currency-hedged, since currency volatility can often be higher than price volatility of the underlying investment."

Seager-Scott refers to a strong preference for similar hedging in the active-management space, fuelling expectations that demand for currency hedging will remain strong in fixed income.

Townsend Lansing, head of ETCs at ETF Securities, says: "Beyond performance, currency hedging can refine exposure to an underlying benchmark. An international portfolio manager with a bullish view on particular foreign sectors, but no view on underlying currency movements, may use currency hedged products as a way of mitigating unwanted currency exposure.

"Therefore, the success of currency hedging strategies cannot simply be measured through relative returns, but rather on the ability of the strategy to offset unwanted risk."

Gains elsewhere

In January, Zacks Equity Research suggested the flow of hedged ETFs would slow down – if not halt – in the second half of the year as the dollar stays steady, and investors look elsewhere for gains in foreign markets.

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Viktor Nossek,
WisdomTree Europe

However, Viktor Nossek, director of research at WisdomTree Europe, suggests 2016 might still prove to be a macro environment where investors choose to be allocated into ETFs, most notably currency hedged ETFs – especially when seeking exposure to eurozone equities. 

Currency-hedged ETFs are here to stay, says Deutsche Asset Management ETF strategist Eric Wiegand. "They have proved their worth and many investors – even if they foresee a period of, for example, low US dollar volatility – still want to remove the FX risk from their equity or bond exposure.

"Currency hedged ETFs are not only used speculatively, but as long-term buy-and-hold investments for investors that want to take a view on equities or bonds, but not currency."

Even if investors lost interest in hedging their US dollar exposure, there would be other, more volatile currencies that would attract interest, he adds.

"However, it is not at all clear that low currency volatility would lead to a fall in demand for a particular currency hedging strategy," says Wiegand. "Many investors are driven by the impetus to reduce the currency exposure, as opposed to taking a tactical currency position."

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Townsend Lansing,
ETF Securities

For many, currency hedged ETPs are a low cost, transparent and operationally efficient means of mitigating unwanted currency exposure during a period of unprecedented central-bank activity and ETF Securities’ Lansing reckons this is unlikely to change, even if low US dollar volatility comes to pass, especially for those investors that are hedging non-dollar currency pairs.

However, Alan Miller, founding partner and chief investment officer at SCM Private, notes that the popularity of hedged ETFs has coincided with a period of notable currency falls for the yen and euro currencies.

"It is arguable that the majority of this competitive devaluation has already taken place, which means that for many investors these hedged currency ETFs are to be avoided as many [from here] will produce a lower return and for a higher cost," he says.

"For example, for the year to February 25, the iShares Japan ETF in sterling produced a return of -4.6% as against -16.4% for the iShares Japan GBP hedged ETF."

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Eric Wiegand, Deutsche

According to Miller, many investors have seemingly forgotten the attractions of what he refers to as 'natural hedging’.

"Many overseas equities markets have a degree of natural currency hedging – for example, when the yen has seen sharp falls, the Japanese equity market in local terms has risen as investors have reappraised the benefits for many large Japanese exporters," he concludes.

"Of course, the reverse is true. Therefore, in a sense, buying foreign equity hedged ETFs can actually increase the risk – if the foreign currency appreciates, you do not receive the benefit whilst this often leads to corresponding falls in the market."