Brown Brothers Harriman s ETF newsletter The Rise of Currency Hedging Introduction... 2 Product Evolution... 3 Challenges for Investment Managers... 4 What is Passive Currency Administration (PCA)?... 5 Conclusion... 6
Welcome to, BBH s ETF Newsletter Introduction Welcome to the second edition of! As mentioned in our first newsletter, our intent is to make these publications as insightful as possible and worth your time, so please send us any feedback you might have for ideas for future editions ETFs and ETPs listed globally have continued to enjoy record breaking growth during the first half of 2014, reaching over US $2.6 trillion in global assets. Product innovation, institutional investor utilisation, retail investor education and continued growth in global distribution channels are all factors contributing to this tremendous growth. As advisors and investors have become increasingly aware of the potentially erosive effects of currency fluctuations on portfolios, currency hedged ETFs have gained appeal. They represent an area of product innovation that continues to attract the interest of ETF investors and managers. Currency hedged ETFs have infiltrated every asset class and have seen inflows of more than $15 billion since the start of 2013. Creating a currency hedged ETF product, provides investors with greater choice and potentially opens greater distribution opportunities for managers. However, launching this type of product comes with its challenges. Building the operational infrastructure to support a physical hedging program introduces operational cost and risk. Additionally, expertise is required to calibrate the hedging program to optimise the balance between transaction costs and performance tracking error. The second edition of will focus on the evolution of hedged and unhedged ETFs and passive currency administration. Jay Moore Senior Vice President, Global Head of Product Development: Foreign Exchange jay.moore@bbh.com +1-212-493-4903 Andrew Craswell Vice President, European ETF Business Development andrew.craswell@bbh.com +44-207-614-3992
Product Evolution Although currency exposure may enhance or erode investment performance, it is typically a by-product of international investing rather than a deliberate decision made by the investor. Launching an un-hedged and hedged version of the same ETF offers a tactical investment choice within the same platform. It also increases investor awareness of the potential impact of currency fluctuations. The hedged version of the product allows investors to mitigate the effect of currency movements and isolate the local returns of the underlying investments. Moreover, the growing universe of currency hedged benchmarks is an indication of strong investor demand which has caused ETF providers to react with new products at an increasing pace. The direct cost of running the hedged version of the ETF is normally passed onto the end investor in the form of a slightly higher total expense ratio (TER) (around 5 to 15 bps). However, the cost of using the hedged ETF for the investor may be insignificant in comparison to the potential impact of currency fluctuations on the ETFs performance versus its benchmark. If we look back to 2013, the Japanese market provides an excellent example of when a hedge product could be utilised. As the local Japanese equity returns surged, the Japanese Yen was falling against the USD resulting in lower returns when left unhedged. Per the below graph and table, the simulated USD hedged index of the Japanese equity market returned 64.73% during the period of January 2012 through June 2014. The un-hedged simulation of the same USD index returned 28.05% over this period. These moves in the Japanese market generated substantial inflows into ETF products that were hedged against the currency fluctuations. By offering both versions of the product within the same platform, ETF managers can retain assets on their platform as investors move between the two versions as their view of the currency changes. Japan: Hedged vs. Unhedged return indices Local Index JPY Simulated Hedged Index Unhedged Index USD Currency Index 2.00 1.80 1.60 1.40 1.40 1.00 0.80 0.60 Jan. 12 Apr. 12 Jul. 12 Oct. 12 Jan. 13 Apr. 13 Jul. 13 Oct. 13 Jan. 14 Apr. 14 Local (JPY) Unhedged (USD) JPY Currency Index (against USD) Simulated Hedge (USD) Total Return 70.01% 28.05% -24.68% 64.73% Annual Return 28.46% 11.42% -10.06% 26.32% Annual Standard 20.66% 18.55% 9.55% 20.57% Deviation Annual Tracking Error - 9.58% - 0.57% Annual Transaction Costs - - - 0.04% * 01/03/2012 to 06/16/2014 The Japanese example is extreme; however, we see this as a potential scenario with other currency pairs as central bank policies change in response to strengthening global economies. 3
Challenges for Investment Managers The key challenges for an ETF manager (or any asset manager) are the increased cost and risk associated with running a currency hedging program and the potential impact on performance and tracking error. In some instances, managers are administering currency hedging programs on Excel Spreadsheets with complex macros which introduce operational risk and distract from their core investment management function. The sensitivity to tracking error is particularly prevalent for ETF managers who are trying to isolate the return of a particular investment or index. The performance of the hedged ETF is dependent on a number of factors that have to be carefully managed through the calibration of the hedging program: Transaction Cost Spread on currency forwards Impact performance and increase tracking error Underlying Performance Creates potential inaccuracies in currency hedges Positive or negative on performance and increase tracking error Operational Risk Program management increases operational risk Impact to investment manager having to compensate fund TER Higher TER to cover expense of running program Impact performance and increase tracking error 4
What is Passive Currency Administration (PCA)? The concept of launching a currency hedged version of an ETF is a straightforward one. The challenge comes in building a scalable solution that can support multiple strategies, asset classes and currencies in the same investment vehicle. The question of transparency is also becoming increasingly important in the world of Foreign Exchange, and having a robust reporting platform allows an asset manager to demonstrate due care and attention to investors. When looking at an effective currency hedging solution, we encourage asset managers to focus on four key areas: 1. Customised Program Design Effective passive hedging programs rest on clear rules-based processes. These rules must be properly defined to balance the trade-off between tracking error and costs. Critical hedging parameters include forward contract tenor, rebalance frequency, trading filters and execution timing. The calibration of these parameters will significantly influence a fund s performance and drive how competitive your offering is relative to your peers. 2. Operational Efficiency Although a set of well-calibrated parameters will ensure precise design, the day to day success of the program will depend on how robust your operational process is. Most managers use customized spreadsheets to perform daily hedge calculations. Although such an approach may provide a short-term solution, the long-term risks of these models are often overlooked until it is too late. 3. Execution Expertise Defining effective execution for FX hedging does not always follow conventional thinking. Depending on what is driving the trading decision (investor flows or underlying NAV valuation changes), appropriate execution timing may differ. It is important to understand the accounting methodologies and availability of exposure data when making trading decisions and measuring execution. 4. Detailed, Transparent Reporting Both operational and execution decisions cannot be measured for appropriateness without transparent reporting. The ability to demonstrate the why and why not of your operational decision process is as important to internal risk teams as the transparency of performance is to your investors. Detailed reporting will ensure all aspects of the hedging program are well presented and promote better decisions. 5
Conclusion Offering currency hedged share versions of the same ETF strategy, allows ETF managers to offer a greater breadth of product in a low cost manner. Outsourcing the currency hedging administration to a scalable platform, allows managers to focus on their core investment management function, and lifts out the operational risk associated with this activity. Finally, given the importance of tracking error to an ETF manager, it is important to calibrate hedging parameters of your program to find the right balance between optimising performance and minimising transaction costs. Please feel free to contact us with questions about how to evaluate the effectiveness of your currency hedging program. To learn more about BBH s Global ETF Services, please contact: Global Head of ETF Services: Shawn McNinch +1.617.772.1376 shawn.mcninch@bbh.com Europe: Antonette Kleiser +353.1.603.6465 antonette.kleiser@bbh.com Europe: Andrew Craswell +44-207-614-3992 andrew.craswell@bbh.com Asia: Scott McLaren +852.3756.1620 scott.mclaren@bbh.com U.S.: Brian Reilly +1.617.772.1321 brian.reilly@bbh.com 6
1513_13 New York Beijing Boston charlotte chicago denver dublin grand cayman hong kong Kraków london luxembourg new jersey philadelphia tokyo wilmington zürich www.bbh.com This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ( BBH ) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ( EEA ), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority. BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. Brown Brothers Harriman & Co. 2014. All rights reserved. 07/2014. IS-2014-07-23-0678