How to hedge out currency volatility with ETFs

Townsend Lansing_ETF securities

In the past year, acquiring protection against growing currency volatility has become increasingly important. The onset of the Greece debt crisis and the very active role that central banks are playing in monetary policy has driven large currency movements, highlighting the impact of “incidental” currency exposure in portfolios holding foreign assets.

Currency hedged and currency ETPs can serve two primary purposes: allow investors to focus on investment objectives by offsetting the effect of currency fluctuations on foreign investments and provide investors with a means of expressing a view on a currency rate and an underlying asset simultaneously. 

Currency ETPs deliver foreign exchange rate performance and can be used to implement hedges against existing currency risks in a portfolio. The choice between delta-1 or leveraged currency ETPs has a considerable impact on the nature of any hedging programme implemented.

Delta-1 ETPs require an initial capital outlay equal to the exposure that needs to be hedged, whereas leveraged ETPs need only a fraction of this amount (more leverage means less capital). Currently capital efficiency is of prime importance to investment strategies, which has made leveraged ETPs the more preferred option.

However, the performance of a leveraged ETP is subject to compounding, meaning that the performance over a particular period is a function of the percentage gain or loss during that period and the cumulative gain or loss on the initial investment. Therefore, the use of leveraged currency ETPs over longer periods requires monitoring and discipline with rebalancing. The more volatile an underlying asset the more frequent rebalancing will be needed.

For many investors, a currency hedged ETP can provide a simpler hedging solution, providing exposure to an underlying asset with a built-in currency hedge. This allows investors to focus on assessing the underlying asset based on its fundamentals and less about currency risk. The ’hedging’ element of a currency hedged ETP is built into the underlying index that the ETP tracks. The benefit of this is that the investor need not worry about managing the currency hedge separately.

For both products rebalancing frequency is an important factor that can impact the cost and performance of the hedge. For a direct currency hedge, rebalancing can occur either periodically or when certain predefined thresholds are breached. Whereas for currency hedged ETPs rebalancing typically occurs periodically (monthly or daily).

A higher rebalancing frequency would ensure a more accurate currency hedge, however it would also increase its cost. Thus, the length of rebalancing periods and the size of thresholds essentially becomes an optimisation exercise of minimising cost while maximising the accuracy of the hedge.

It is important to remember that investors may not always want to be hedged or to hedge every foreign investment. Indeed, in a low volatility environment, the currency hedge may impose additional costs with little upside. Naturally, when executing a hedging strategy, investors should clearly define their goals, including both their views on the relevant currencies as well as the need to reduce friction from currency volatility. A decision to currency hedge should be completely unique to the circumstances and objectives of each individual portfolio.

Currency risk arises from investing in foreign markets. At a time when currency volatility is likely to persist, hedging can prove beneficial for both short-term tactical investors looking to mitigate currency risk in their portfolio and long-term strategic investors. If the currency exposure is ignored a portfolio can find its risk-return profile distorted by currency volatility. Currency hedged and currency ETPs can be an effective and efficient means of implementing a currency hedging programme in an international portfolio.