Bloomberg data show almost €400 million of outflows from European domiciled currency-hedged equity ETFs last year, and even heightened demand for hedged fixed income and commodity products failed to prevent a near 13% fall in overall European domiciled currency-hedged ETF inflows.
However, 2017 has seen a sizeable return in interest from investors, with overall inflows up by almost €7.2 billion for the year to the end of April – more than 40% higher than the total for the whole of 2016.
According to Nizam Hamid, head of ETF strategy at WisdomTree in Europe, currency volatility has reminded investors of the risks of holding unhedged exposures.
Managing currency risk has returned to the fore, especially when investing in markets such as Japan, he says, adding: “The key for investors is to understand that when buying equities, typically they only want to access the local equity return without the complications and risks of currency movements.”
The strengthening of the euro to the US dollar has raised demand for euro, sterling and Swiss franc hedged exposure by European-denominated international investors, observes Eric Wiegand, ETF strategist at Deutsche Asset Management.
Townsend Lansing, executive director head of ETCs at ETF Securities, suggests currency hedged ETFs are always relevant to investors who wish to make portfolio allocations to global assets.
“Volatility and event risk are likely to remain high and, as a result, currencies will continue to impact investment returns,” he says. “We saw strong flows in 2015 and 2016, and have seen only limited redemptions in our currency hedged commodity range.”
Some investors use currency hedged ETFs to get long-term international exposure without the currency risk, while others use them more tactically, taking the view that the currency they are invested into is likely to weaken versus their home currency.
The general difficulty of calling currencies means investors should only make tactical calls where there are compelling reasons for such a call and should hedge overseas exposure if the volatility of the currency is greater than that of the underlying asset class.
That is the advice of Ben Seager-Scott, chief investment strategist at Tilney Group, who notes that for developed markets, this generally means unhedged equities and hedged fixed income is a good starting point.
Choosing a strategy
Currency hedging approaches can be broadly divided into three categories – daily hedged, monthly hedged and partially (50/50) hedged – and are determined by expectations for the currency pair the customer is exposed to, the strength of their conviction in currency movements and the underlying volatility of the asset they are investing in, explains Chris Mellor, executive director of equity product management at Source.
|Chris Mellor, Source|
“Daily hedged gives the most effective hedge of currency exposure, resetting the hedge daily to reflect the value of the underlying assets, but comes at a higher cost for implementing the daily resets,” he says.
“A monthly hedge is cheaper to implement, but any changes to underlying asset values intra-month will not be covered. The partial hedge is likely to be the least expensive option, but you are, of course, only partially hedged.”
Many of the largest benchmarks – S&P 500, MSCI World, etc – are priced in US dollars, so expectations for a continuation of recent dollar weakness is likely to prompt an acceleration of inflows for currency hedged ETFs, says Mellor.
“When we look at the flows for European domiciled hedged ETFs year-to-date [a period over which the dollar has weakened slightly], more than half of the €3.8 billion of flows into equity hedged ETFs are into products offering a hedge against dollar exposure,” he says.
WisdomTree’s Hamid agrees, referring to political risk in the eurozone, US and UK that could spark dramatic moves in exchange rates, adding that with policy in Japan favouring a weakening of the yen to stimulate domestic demand, that currency could fall further.
|Eric Wiegand, Deutsche|
Wiegand at Deutsche adds: “Those investors who are denominated in sterling and already have international exposure [and therefore benefited from sterling’s decline last year] might now be tempted to switch into sterling hedged international equity exposure to try to lock in those gains.
“On the back of this, we have seen strong inflows into our S&P 500 GBP hedged ETF.”
However, Ben Gutteridge, head of fund research at Brewin Dolphin, observes that while the investment manager has a modestly positive bias towards sterling assets on the basis that the currency looks a little on the cheap side, it has reallocated some of its international equity exposure into domestic stocks rather than buying currency hedged ETFs.
Tilney’s Seager-Scott also sounds a cautionary note.
He concludes that while the fall in dollars relative to euros during the past six months would suggest greater demand for dollar investors to hedge the currency – if they believe it will bounce back – this can be psychologically challenging as they see currency hedged positions underperform unhedged positions; effectively a mean-reversion-versus-momentum challenge.