Vexed questions on currency hedging

To hedge or not to hedge? That is not the only question regarding the currency risks that come with investing across borders.

If one gets past the "whether to hedge" question, there is also the "when" and the "how". Investors in a popular exchange traded fund may not be so much hedged against a rising dollar as leveraged to it, something that could become apparent if the dollar rally runs out of steam.

These have become increasingly vexatious questions for equity investors. It has become a mantra for advisers that clients should be diversified geographically as well as by sector, even though most stock markets contain enough multinational companies to provide exposure to the global economy beyond domestic borders. And so we have more investors buying international stock funds at a time of significant gyrations on foreign exchange markets.

When the US dollar can strengthen by 20 per cent against other currencies in a year, a US investor who has put money overseas will find it buys them much less than they were hoping when they bring it back home, regardless of how well foreign stock market indices have done.

An American investing in the MSCI European Monetary Union index would have lost 8.4 per cent in 2014, in US dollar terms, even though the index was up a decent 4.6 per cent in local currency.

Inevitably, interest in currency hedging has surged, and financial engineers have served a full menu of new hedging products.

Chief among these are exchange traded funds that combine overseas stocks with foreign exchange contracts to hedge out any currency fluctuation. These have been the flavour of the past few months in the US, perhaps unsurprisingly as the dollar has surged and the value of overseas assets has fallen in dollar terms. Of the 10 US ETFs to have gathered the most assets this year, four are currency-hedged international stock funds, taking in $21.1bn in total.

Chief among them has been the WisdomTree Europe Hedged Equity ETF, which alone has gathered $10.6bn in assets, more than doubling in size. With the European Central Bank embarking on quantitative easing as the US Federal Reserve winds its own programme down, the fund has been a good bet on the resulting devaluation of the euro against the dollar.

Investors need to be careful to distinguish between ETFs with different methodologies.

Unlike peers, such as the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (which has gathered $5.7bn year-to-date), the WisdomTree fund is "double hedged". It screens out European companies that make most of their sales in the eurozone. focusing instead on exporters that will do better if the euro declines. If last week's US jobs report tips the see-saw back from the dollar towards the euro, on the theory that US interest rate rises are further away than previously thought, then the fund's holders could lose two ways.

The multidimensional currency calculations embedded in the WisdomTree ETF prompted S&P Capital IQ, the fund ratings firm, to issue an alert last week urging investors to be cautious. The fund has outsized weightings in three companies - L'Oreal, Unilever and Anheuser-Busch InBev - that are on S&P's sell list for various reasons, a reminder that investors should always look through to an ETF's holdings.

The biggest objection to currency-hedged ETFs is they encourage investors to try to time the foreign exchange markets, with little evidence they are likely to be successful in doing so. The forward contracts used by these ETFs also do not come for free, raising costs beyond those typical for overseas equity funds, let alone domestic funds.

As vehicles for currency speculators, currency-hedged ETFs may have their place, but such hedging does not typically contribute to returns over the long run.

For US investors, there are reasons beyond portfolio diversification to consider European stocks at this point. The US bull market is further advanced, and domestic stock valuations more stretched; Europe is at an earlier stage of this elongated, post-crisis economic cycle. In addition, the eurozone stock market is valued at just 52 per cent of the region's annual GDP, versus 138 per cent in the US, according to Guggenheim Securities. It has plenty of recovery potential - but if that is fulfilled over the long run, that ought to mean the euro goes back up anyway.

If one can suffer the slings and arrows of outrageous short-term currency moves, it will be nobler to do so.

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