Purer return and reduced volatility: Hedging currency risk in international-equity portfolios Currency-hedged exchange-traded funds (ETFs) offer investors a compelling way to access international-equity markets and potentially achieve superior precision within portfolios. In our view, currency-hedged ETFs remain an underutilized risk-management and portfolio-building tool. Moreover, the case for hedging currency is particularly relevant in today s environment, when many investors are forecasting a stronger U.S. dollar. Overview In addition to their low cost, tax efficiency, liquidity and transparency, ETFs have also delivered the benefits of market access and investment precision to investors. Market segments that were once difficult to access, such as gold and China A-shares, are now available to a broader investor base, thanks to ETFs. Additionally, today s investors are empowered to better control for unintended risks and achieve precise exposures within their portfolios by using increasingly sophisticated ETFs. Currency-hedged ETFs, which allow investors to buy regional equities while controlling for currency risk, are an excellent example of the intersection of access and precision. In our view, they remain underutilized risk-management and portfoliobuilding tools particularly in today s environment, when many investors are expecting a stronger U.S. dollar. It s no surprise that over the past decade, U.S. investors have dramatically increased the proportion of their equity allocations to exposures outside the United States. International equities now comprise more than 50% of the world s equity market capitalization and contribute to roughly two thirds of the world s gross domestic product (GDP) growth. For U.S. investors, currency returns have largely enhanced the performance of unhedged international equity investments over the past decade. This will not remain the case indefinitely. As unhedged investors have found in recent years, a declining U.S. dollar will positively contribute to the returns of unhedged foreign-market investments but a soaring U.S. dollar will do the opposite, detracting from returns. Currency movements present an element of uncertainty for U.S. investors holding mutual funds and ETFs that invest in international equities. In this white paper, we will explain the effect that exchangerate movements have on the return of mutual funds and ETFs that hold foreign securities, discuss how exchange-rate risk can be mitigated through currency hedging, and describe why investors should view currencies within their portfolios as a contributor to both risk and return. Contributors Dodd Kittsley, head of ETF strategy and national accounts, Deutsche Asset & Wealth Management Abby Woodham, ETF strategist, Deutsche Asset & Wealth Management
What is currency risk? Foreign currencies are a significant, yet underestimated, driver of risk and return in any international equity investment so much so, in fact, that we refer to this phenomenon as currency risk. Currency risk is the possibility that the price of one currency will change relative to another over the course of an investment horizon, altering the return of a foreign-currency-denominated investment. The buying and selling of domestic stocks takes place in U.S. dollars, meaning domestic investors (or funds that invest in domestic equities) don t need to exchange currencies during these transactions. International stocks, on the other hand, are bought and sold in their own local currencies, meaning U.S. investors and U.S.-listed ETFs and mutual funds must convert U.S. dollars to a local currency in order to make a purchase. Then, when eventually selling, the ETF or mutual fund must exchange the proceeds, denominated in the local currency, for U.S. dollars. If the exchange rate between the dollar and the local currency has changed since the purchase date, however, the total return of the investment will be impacted. Figure 1 illustrates. Figure 1: Domestic vs. international investments Domestic investment International investment Total return = equity return This chart is for illustrative purposes only. Total return = equity return +/ currency return As an example of how currency risk works, consider an investor wants to buy $150,000 worth of shares of the German company Bayer, which is a euro-denominated stock. The exchange rate is $1.5 = 1, so the investor exchanges $150,000 for 100,000 worth of Bayer shares. Over the course of the investment, the stock price doesn t change, and the investor decides to sell the shares for 100,000. When it s time to exchange the euro-denominated proceeds of the sale for U.S. dollars, however, the investor finds that the exchange rate has changed to $1 = 1. This would be great news for American tourists in the Eurozone, but it s bad news for the investment. The 100,000 is exchanged for $100,000, meaning the investor realized a 33% loss even though the share value remained unchanged. Figure 2 illustrates. Changes in exchange rates can and do significantly impact unhedged investments in international equities, and real-life examples of the currency effect abound. Toyota Motor Corp. returned 63.1% in 2013 for Japanese investors buying the stock on the Tokyo exchange, but dollar-denominated U.S. listing of Toyota returned only 33.4% because the U.S. dollar strengthened against the yen in 2013. For a U.S.-based investor, more than 47% of the stock s return was lost to changes in the exchange rate. International investors who make unhedged investments in U.S. equities suffer the same effect. The S&P 500 performed well in 2010, for example, returning 15.1%. However, Japanese investors who bought an unhedged investment in the S&P 500 saw flat returns for the year because the yen strengthened considerably against the dollar. Changes in the exchange rate between the U.S. dollar and yen completely wiped out the equity return of the S&P 500. How currency hedging works An international equity ETF or mutual fund can be fully exposed to currency returns, or it can mitigate currency risk through hedging. The objective of currency hedging is to remove the effects of foreign-exchange movements, giving U.S. investors a purer return that approximates the return of the local market. Within ETFs and mutual funds, currency hedging is typically accomplished through currency forward contracts, which are agreements between two parties to buy or sell Figure 2: How currency risk can hurt returns $150,000 exchanged for 100,000 Stocks purchased with 100,000 100,000 exchanged for $100,000 Exchange rate $1.5 = 1 Price unchanged over month Exchange rate $1 = 1 $150,000 $1.5 = 1 100,000 + shares 100,000 $1 = 1 $100,000 $100,000 This chart is for illustrative purposes only. 2 Purer return and reduced volatility
currencies in the future at an agreed-upon exchange rate. Currency forwards allow portfolio managers to protect their investments from potential swings in exchange rates. In this regard, currency forwards can be thought of as insurance against a negative event. Let s return to our earlier example in which an investor exchanges $150,000 to buy 100,000 of Bayer stock. When it came time to sell, the investor lost money, not because the stock s price has changed, but because the exchange rate has gone to $1 = 1. Instead of realizing a 33% loss to the currency effect, the investor could have hedged the investment by selling a currency forward contract that locked in the future exchange rate between U.S. dollars and euros. In other words, the investor would make an agreement with another party to sell 100,000 for $1.50 per euro, or $150,000, at a specified date in the future (say, one month). At the end of the month, when the exchange rate had shifted to $1 = 1, the investor would sell the shares for 100,000. Under the terms of the contract, the investor would then sell that 100,000 to the counterparty for $150,000. Because the investor locked in the exchange rate at the beginning of the month, he or she received the same flat return of a local investor instead of a loss. Currency hedging helps investors avoid the distortion of the currency effect on their international investments, getting them closer to the returns that local investors receive. For example, the yen-denominated MSCI Japan returned 54.6% in 2013; the U.S.-dollar-denominated version of the index returned 27.2%, thanks to the weakening yen. The MSCI Japan 100% Hedged, which is hedged on a monthly basis, returned 53.0% for the year. Hedged investors received returns that were more representative of Japanese equity performance. To hedge or not to hedge? Given that the returns from currencies can either add or detract from the total returns of a foreign investment, investor can either elect to hedge or not hedge currency risk. Investors with a view of the U.S. dollar relative to foreign currencies should ensure that their foreign market investments reflect their currency outlooks, either by being hedged or unhedged as the case may be. On a total return basis, currency-hedged investments should outperform corresponding unhedged investments during periods when the U.S. dollar is strong. Conversely, when the U.S. dollar weakens, currency-hedged investments generally underperform. Is your investment implicitly short the U.S. dollar? Investments in equities, mutual funds and ETFs denominated in another currency are implicitly short the U.S. dollar: If the U.S. dollar strengthens over the course of the investment horizon, the foreign currency will be exchanged for fewer U.S. dollars at the time of sale. However, today s investors have the ability to control for this risk and can neutralize the impact of currencies in an efficient manner with currency-hedged ETFs. Figure 3: Currency s impact on return (in percentage points) local currency MSCI EAFE MSCI Japan MSCI ACWI U.S. dollars Currency impact on return local currency U.S. dollars Currency impact on return local currency U.S. dollars Currency impact on return 2004 12.7 20.2 7.5 10.8 15.9 5.1 13.1 20.9 7.8 2005 29.0 13.5 15.5 44.6 25.5 19.1 29.5 16.6 12.9 2006 16.5 26.3 9.8 7.3 6.2 1.1 18.1 26.7 8.6 2007 3.5 11.2 7.7 10.2 4.2 6.0 8.5 16.7 8.2 2008 40.3 43.4 3.1 42.6 29.2 13.4 40.9 45.5 4.6 2009 24.7 31.8 7.1 9.1 6.3 2.8 31.7 41.4 9.7 2010 4.8 7.8 3.0 0.6 15.4 14.8 7.6 11.2 3.6 2011 12.2 12.1 0.1 18.7 14.3 4.4 12.2 13.7 1.5 2012 17.3 17.3 0.0 21.6 8.2 13.4 16.3 16.8 0.5 2013 26.9 22.8 4.1 54.6 27.2 27.4 20.1 15.3 4.8 Source: Morningstar as of 9/1/14. Performance is historical and does not guarantee future results. returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. Purer return and reduced volatility 3
Take, for example, an investor who believes the U.S. dollar may depreciate against foreign currencies. If this investor is seeking to invest in international equities, an unhedged ETF may be more suitable. If the investor s assumption is correct, he or she will receive the returns of the underlying securities as well as the gains of the local currency relative to the U.S. dollar. On the other hand, hedged international equity ETF may be the better solution for an investor who believes the U.S. dollar will appreciate. If the investor s view proves accurate, he or she will receive the returns from the underlying securities while the negative impact of the stronger U.S. dollar is mitigated. Currency-hedged investments aren t just for investors with an active view of future fluctuations in exchange rates. The impact of currency on total return can be extreme and unpredictable. Investors without an opinion on future exchange rates may want to consider removing the currency component from their total return lest the equity return (and underpinning of their investment thesis) be swamped out. As Figure 3 shows, currency s impact on total return can be extreme and unpredictable. From 2007 through September 2012, the yen strengthened considerably against the U.S. dollar. During that period, the average 12-month period saw the MSCI Japan outperform the MSCI Japan 100% Hedged by an average of 7.5 percentage points. The trend reversed in 2012 as the Bank of Japan initiated its aggressive quantitative-easing policy. The hedged index outperformed the unhedged index by 11.6 and 25.8 percentage points in 2012 and 2013, respectively. Another reason to consider hedging currency risk is that over shorter periods of time, currency-hedged investments have historically been meaningfully less volatile than their unhedged counterparts. The reduction in volatility has been significant to the point of providing potentially superior risk-adjusted return. Over the past 10 years through the second quarter of 2014, the five currency-hedged MSCI indexes shown in Figure 4 (with the exception of Japan) averaged lower 12-month volatility than their unhedged counterparts. The reduction in volatility also meaningfully boosted risk-adjusted return for the hedged indexes relative to the unhedged. In the case of Japan, where the unhedged index exhibited less volatility, the hedged index did not suffer massive losses due to the strengthening dollar in 2013. As a result, the hedged index also had a higher average Sharpe ratio, as shown in Figure 5. Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04 6/30/14) Hedged Unhedged 13.4% 16.8% 18.3% 14.9% 16.7% 22.3% 17.0% 22.4% 13.3% 17.5% MSCI EAFE MSCI Japan MSCI Emerging Markets MSCI Germany MSCI AC World Ex-USA Source: Morningstar as of 6/30/14. Performance is historical and does not guarantee future results. Hedged indices are as follows: MSCI EAFE 100% Hedged, MSCI Japan 100% Hedged, MSCI Emerging Markets 100% Hedged, MSCI Germany 100% Hedged, and MSCI ACWI ex-u.s. 100% Hedged. returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. Figure 5: Average rolling one-year Sharpe ratio over 10 years (7/1/04 6/30/14) Hedged Unhedged 0.84 0.76 0.78 0.76 0.97 0.87 0.89 0.79 0.37 0.25 MSCI EAFE MSCI Japan MSCI Emerging Markets MSCI Germany MSCI AC World Ex-USA Source: Morningstar as of 6/30/14. Performance is historical and does not guarantee future results. Hedged indices are as follows: MSCI EAFE 100% Hedged, MSCI Japan 100% Hedged, MSCI Emerging Markets 100% Hedged, MSCI Germany 100% Hedged, MSCI AC World Ex-U.S. 100% Hedged. returns do not reflect fees or expenses, and it is not possible to invest directly in an index. See back page for index definitions. 4 Purer return and reduced volatility
What drives currency moves? A widely followed economic theory, purchasing power parity, holds that there is an equilibrium real exchange rate between currencies over the long term. Currencies exhibit mean reversion over time, and have a long-term expected return of zero. This would imply that currency hedging isn t worthwhile. In reality, however, exchange rates can deviate substantially from this equilibrium rate, especially in the short term. While many investors today may not have a holistic view of currency movements or a formal currency outlook, they likely do have an opinion on some of the economic factors that also drive currency values. Below are some key contributors to currency market movements. Monetary policy. When central banks raise interest rates, the country s bonds and other local assets appear more attractive relative to other countries. The country s currency will therefore appreciate as its assets are purchased by foreign investors. This effect can be particularly pronounced in emerging market countries. Inflation expectations. If investors anticipate higher future inflation, they generally expect the central banks to raise interest rates. Balance of trade. If foreign demand for a country s goods increases, the country s currency will appreciate. Conversely, if a country increases its import rates, all things being equal, that country s currency will depreciate. Conclusion Despite growing to a $14 billion segment of the U.S. ETF market, currency-hedged ETFs remain a very small (less than 4%) segment of international equity ETFs. So why aren t more investors buying currency-hedged ETFs? We believe the primary cause has been the U.S. dollar s deprecation over the past eight years, which has provided a tailwind to unhedged international equity portfolios. Risk without pain or consequence can often be tolerated or forgotten by investors until the environment shifts. Additionally, the ability to hedge through forwards and other derivatives was limited to the largest investors in the world until recently. Smaller investors were largely limited to unhedged investments. Currency-hedged ETFs are a relatively new investment tool of which investors may not be fully aware. Today, investors are no longer forced to assume currency risk as a natural byproduct of investing in international equities. With the advent of currency-hedged ETFs, investors have fewer barriers to entry (such as scale and cost) for the ability to tactically control currency-driven risk and target currency-driven return potential. The impact of currencies and the decision to hedge this type of risk seems to be growing in importance as investors appetite for international equities continues to grow. Currency returns will likely continue to fluctuate considerably and have a meaningful impact on investors realized returns. Investors in foreign equities can consider hedging currency risk to receive purer return and potentially reduce volatility. Purer return and reduced volatility 5
Definitions: One basis point equals 1/100 of a percentage point. China A-shares are shares of mainland-china-based companies that trade on Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange. Mean reversion is a theory that prices and returns eventually move back toward the mean, or average. The MSCI All Country World (ACWI) tracks the performance of 23 developed and 23 emerging markets; the MSCI AC World ex-us 100% Hedged is the currency-hedged version of the index. The MSCI EAFE tracks the performance of stocks in select developed markets outside of the United States; the MSCI EAFE 100% Hedged is the currency-hedged version of the index. The MSCI Emerging Markets tracks the performance of stocks in select emerging markets; the MSCI Emerging Markets 100% Hedged is the currency-hedged version of the index. The MSCI Germany tracks the performance of German stocks; the MSCI Germany 100% Hedged is the currency-hedged version of the index. The MSCI Japan tracks the performance of Japanese stocks; the MSCI Japan 100% Hedged is the currency-hedged version of the index. The S&P 500 tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. Shorting is borrowing then selling a security with the expectation that the security will fall in value. The security can then be purchased and the borrower repaid at a lower price. Standard deviation is often used to represent the volatility of an investment. It depicts how widely an investment s returns vary from the investment s average return over a certain period. The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of Deutsche Asset & Wealth Management, are as of September 2014 and may not come to pass. Investing involves risk, including possible loss of principal. Funds that invest in specific countries or geographic regions may be more volatile than investing in broadly diversified funds. Securities focusing on a single country may be more volatile. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable currency fluctuations, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There are additional risks because of potential fluctuations in currency and interest rates. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and increase volatility. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. 2014 Deutsche Bank AG. All rights reserved. PM145862 (9/14) I-35854-1 RETAIL-PUBLIC CURRENCY-WHITE