What is a currency hedged global ETF?
Global ETFs can be difficult to analyze, because when you look at the performance of a global ETF, you don't know how much of the performance was due to the performance of the foreign markets, and how much the performance was affected by changing U.S. dollar exchange rates. Let's look at an example using IEUR, the iShares Core MSCI Europe ETF. IEUR has performed poorly compared to the S&P 500.
Are the European stock markets really performing that badly? Or are U.S. dollar exchange rates changing a lot. If you look at a chart of IEUR with USDEUR, which is the U.S. dollar spot exchange rate with the Euro, you can see that at different time frames, there have been dramatic changes in the U.S. dollar to Euro exchange rate, which obviously has affected IEUR's price chart.
Looking at U.S. dollar exchange rates helps you analyze IEUR, but it is still difficult to piece together the real picture of what is going on. If you are lucky, you can also find a version of the same index that is denominated in the local currency. Unfortunately, it is often difficult to find a local currency index that matches the U.S. dollar index.
You can also see our list of currency hedged ETFs.
How does foreign currency hedging work?
Most currency hedged global ETFs achieve their foreign currency hedge by entering into foreign currency forward contracts. A forward contract is a contract with a third-party that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward does not involve any upfront payment. Currency forwards are private contracts, as they do not trade on a centralized exchange. Most currency hedged global ETFs enter into 30 day forward contracts, but that can vary. Forward contracts are available for all kinds of different time periods.
Under a forward contract, an investor agrees to buy or sell a set amount of currency at a future date at an agreed upon "forward rate". The forward rate is the current spot currency exchange rate, adjusted for an interest rate differential. The interest rate differential is the difference between short-term interest rates in the U.S. versus short-term interest rates in the country related to the foreign currency. The currency forward rate is merely based on interest rate differentials, and does not incorporate investors’ expectations of where the actual exchange rate may be in the future.
The idea behind using interest rate differentials is to make the forward contract a binding agreement between two parties that are exchanging equal value. If an investor enters into a $1,000,000 forward currency contract on the Euro with a forward date one year from now, to make the forward contract an exchange of equal value, you have to adjust for different interest rates. $1,000,000 in U.S. dollars invested today at 1.00% interest is worth $1,010,000 in a year. Using a theoretical spot currency exchange rate between the U.S. dollar and the Euro of .91, then 1,000,000 in U.S. dollars today is worth 910,000 in Euros as of today. Those 910,000 Euros will earn interest at a rate of 2% per year (in this theoretical example, Europe has higher short-term interest rates than the U.S). So in a year the 910,000 in Euros will be worth 928,200 Euros. So the one year forward contract is exchanging a theoretical value of 1,010,000 U.S. dollars with a theoretical value of 928,200 Euros. So the "forward rate" is .9190 (928,200/1,010,000), not the current spot rate of .91.
In this example, when the one year forward contract is settled using the forward rate of .9190, the U.S. investor will have lost money on the "interest carry", regardless of what happens with the spot currency exchange rate. The investor's net gain or loss on the transaction will be the "interest carry" plus or minus whatever the difference is in the spot currency rate at the time of settlement.
This "cost of carry" on a forward currency contract varies all the time, as short-term interest rates change in the U.S. and they change around the globe. There can even be times when the U.S. investor will actually make money on the "interest carry", if U.S. short-term interest rates are higher than the rates of the foreign country.
How does this help a global ETF?
Ideally, a global ETF that uses foreign currency hedging enters into forward currency forward contracts that total the value of the stocks and bonds that the ETF is holding that are denominated in foreign currencies. Every day, when a global ETF calculates its net asset value, the global ETF must translate the value of all of its holdings (stocks and bonds) that are denominated in a local currency, into a value in U.S. dollars, using the spot currency exchange rate. This creates an unrealized gain or loss for the ETF. Ideally, this unrealized gain or loss is entirely offset by the gain or loss that the ETF incurs on the forward currency contracts. Theoretically, this means that the performance of the global ETF is strictly related to the performance of the underlying securities (stocks and bonds) and is not related to changing U.S. dollar exchange rates.
Benefits
Currency Exchange Rates Are Difficult to Predict
When you buy a global ETF that does not use foreign currency hedging, you are partially making an "inverse" investment in the U.S. dollar. In a way, you are hoping that the U.S. dollar will weaken, as that will translate to better performance of the global ETF. If the U.S. dollar strengthens, your global ETF will go down in value by the difference in exchange rates. The problem is that it is often difficult to predict what will happen in the future to foreign currency exchange rates. It is especially difficult to predict long term changes in exchange rates. Fifteen years from now, will the U.S. dollar exchange rate against the Euro be lower or higher? It is impossible to know, and most people, including us, have no idea as to how to even make a guess. So at a basic level, it makes sense for a global ETF to use currency hedging, because at least that way an investor can make an informed decision about whether to invest in the global ETF, without having to worry about foreign currency exchange rates.
Easier To Analyze
It definitely is difficult at times to analyze a non-hedged foreign ETF and understand what is really happening. Let's look at EWW, which tracks an index of Mexican stocks.
How much of the down turn in the past few years is because of the Mexican stock market and how much is because the Peso has become devalued against the U.S. dollar? A hedged ETF tries to solve that problem.
Risks
Do they properly track their index?
It is difficult to know, because global ETFs that use currency hedging are so new. The net result of a currency hedged ETF should be that the performance of the ETF tracks the performance of an index that is calculated using the foreign currency. For example, HEDJ, which tracks the WisdomTree Europe Hedged Equity Index, should track the performance of the European stock markets, in Euros (before foreign currency translation to US dollars).
Dividends Are Unpredictable
One effect of the currency hedging is that many of the global ETFs that use currency hedging have been making large dividend distributions (especially at year end), because they are distributing the short and long-term gains generated by the hedging. Are these distributions "normal" and "recurring"? Lately, the U.S. dollar has been really strong. What happens to these dividends when the U.S. dollar is really week? It is difficult to understand and know for sure.
What are the "hedging costs"?
As explained above, if U.S. short-term interest rates are lower than foreign short-term interest rates, the ETF will suffer "carrying costs" associated with the hedging operation. On the other hand, if U.S. short-term interest rates are higher than foreign short-term interest rates, the ETF will actually have a net gain associated with the hedging operation. It is very difficult to track the net affect of this on a global ETF that uses foreign currency hedging.
Do hedged ETFs have a higher correlation to SPY?
UUP has a correlation to SPY over its lifetime of 60%.
By removing foreign currency swings from the price of a global ETF, does that mean that a hedged ETF will be more highly correlated to SPY? Here is a simple summary:
| Category | Hedging Strategy | Average Correlation To SPY |
|---|---|---|
| Global Equity | Uses currency hedging | 76.63% |
| Global Equity | Does not hedge | 45.55% |
| Global Fixed Income | Does not hedge | -14.88% |
| Global Fixed Income | Uses currency hedging | 21.03% |
Is it bad to be more highly correlated to SPY? There are lots of different theories about building long-term investment portfolios. Many people believe that adding global ETFs to their portfolio enhances the stability of the portfolio, partly because global ETFs are NOT as a highly correlated to SPY as other asset classes. Just remember that if you start to add a hedged global ETF to your portfolio. But note that the correlation to SPY for hedged global ETFs is still not that high.
Should a long-term investor hold a hedged global ETF?
We don't think it is smart for a long-term investor to hold a hedged global ETF. As explained above:
- Over the long-term, the performance of the hedged ETF will be worse than the non-hedged equivalent due to the roll-costs associated with the currency hedging
- The hedged ETF will be significantly less tax-efficient than the non-hedged equivalent due to the significant dividends that the hedged ETF will be paying out due to gains and losses on the currency hedging
- The odds are probably greater that the hedged ETF will not be able to accurately track its index, compared to the non-hedged equivalent ETF