If putting together the words “currency” and “hedging” make you want to pull the covers over your head, you aren’t alone. The news is abuzz about the strong U.S. dollar, and it can be confusing how these things relate to your money and investing.
Most of us encounter currency exchange when we open our credit card statements after an international trip and discover that great pair of shoes purchased in Italy translated into less U.S. dollars than expected. At the moment, traveling internationally can mean buying and doing more, thanks to the stronger dollar. My upcoming trip to London may prove a great opportunity to purchase slightly less expensive holiday gifts for my family.
However, when it comes to investing overseas, a strengthening U.S. dollar against the currency of the country you’re invested in can actually reduce your overall return.
For a few years, currency wasn’t a big deal for international portfolios. From 2011 to 2013, the exchange rate between the U.S. dollar and major world currencies, as measured by the DXY currency index, did not fluctuate dramatically, so American investors generally didn’t experience heavy impacts from currency fluctuations.
But in 2014, the dollar started to spike against many foreign currencies, and some U.S. investors have seen the negative effect on their bottom line. In an attempt to dampen down the impact of the stronger dollar, investors have been turning to currency hedged exchange traded funds (ETFs) in a big way. These ETFs seek deliver the return of the investment, while reducing the impact of currency fluctuations.
The flows are actually pretty staggering. So far this year, investors have poured nearly $47 billion into U.S.-listed currency hedged ETFs, compared to $10.1 billion for all of 2014.
Many believe that the U.S. dollar will continue to strengthen, especially as the Federal Reserve starts raising interest rates. It's important to note, however, that while currency hedged ETFs can be a great way to minimize currency risk, there are several things to consider when deciding if this approach is right for you.
Why a strong U.S. dollar hurts
First, you should understand how currency affects your investments. When you buy stocks or some bonds overseas, your return consists of two parts — the market return and the currency return.
The math works like this:
Let’s say you buy 100 shares of a European company for $100. At the time of your purchase, one euro (the price of a European share) equals $1.
Then, a year later, those shares went up 10% and are valued at 110 euros. Great!
However, in that time, the dollar strengthened, and $100 is now worth 125 euros. So even though the share price went up, your initial investment dropped in value to $88 (€110/€125 = 88% or $88). Not so great.
How ETFs can help
Professional investors have long made currency risk a part of their investment strategies, and managed it for years through complicated, sometimes costly, financial methods.
But not until relatively recently have individual investors had a convenient tool to help them reduce this risk. Currency hedged ETFs seek to track an index of foreign stocks or bonds, but they also aim to reduce exposure to fluctuations between the value of the foreign currencies and the U.S. dollar.
This enables you to have the same international market exposures as you would in an unhedged fund, but with potentially reduced risk for diminished returns due to a strengthening dollar.
Investors have been drawn to currency-hedged ETFs because they’re:
Simple to use — ETF providers manage the complicated currency hedging process for you.
Easy to buy and sell — You can trade in and out of a fund at current market prices just like an individual stock, which is important given how quickly stocks and currencies can move.
Versatile — Hedge a wide range of international exposures in one fund or a combination of funds.
ETF providers have been responding to investor demand by expanding their currency hedged offerings. Investors can now choose from a variety of global, regional and single-country options. iShares, in fact, recently added several new currency hedged ETFs to help investors weather market ups and downs, as well as the strengthening dollar.
Should you hedge?
It’s important to note, though, that currency movements swing both ways. If the dollar weakens against a foreign currency, then you would likely see currency gains in an international portfolio instead of losses. And a currency hedged ETF could prevent you from realizing those gains.
Also, in the long run, currency fluctuations have historically balanced out. And the somewhat higher costs of hedging can also reduce returns over time. So for long-term investments, currency hedging might not be the best strategy.
Before you invest in a currency hedged ETF, you should consider your:
Future view of the U.S. dollar — Will it go up, or will it go down?
Investment time frame — How long will you invest in that international market?
Risk tolerance — Do you worry about sudden currency changes?
The bottom line
So, should you jump on the currency-hedge bandwagon?
If you believe the U.S. dollar will strengthen over the foreign currency during your investment horizon, then it might be wise to consider hedging those investments.
But if you believe the U.S. dollar will weaken, or if you are holding the international investment long term as part of a diversified portfolio, then you may not want to hedge your currency exposure.
And if you’re not sure what will happen with currency, you may want to think about dividing your international investment into hedged and unhedged versions of ETFs with the same market exposure.
Whatever your view of the U.S. dollar, ETFs offer a variety of options to help you tailor your international investments toward your financial goals.
