Bridging the Currency Hedging Gap
Last year was not very profitable for many clients in international stocks, and it wasn’t because the stocks fell.
“Most of the overseas markets, in local terms, were positive,” observes New York-based planner Bob Wander. Nonetheless, virtually all the gains turned to losses when translated back to dollars, he says.
Few advisors have the time or expertise to engage in direct hedging via currency swaps or forward contracts. For those who choose to hedge, a growing number of currency-hedged ETFs are available. Through July of this year, more than twice as many of these specialized funds had gone public as in all of 2014.
IN AND OUT QUICKLY
The ETF format appeals to planner Michelle Wells at the Darrow Co. in Concord, Mass. “You can get in and out rather quickly as opposed to utilizing any other kind of structure,” she says.
Attempting to actively hedge investments directly via swaps or futures is too expensive, Wells contends. “To me, there’s no justification for the cost.”
When it comes to currencies, Wells says, “It’s hard to find a long-term trend.” In fact, when Morningstar compared the performance of the hedged versus unhedged MSCI EAFE index over the past 25 years, the results were essentially a toss-up. But that time frame may be too long for most clients.
“There’s theory, there’s practice and there’s reality,” acknowledges Wells, who notes that some clients consider only short-term results. So while Wells uses currency-hedged ETFs, she hedges her bets on her hedges. To wit: Her clients have about 25% of their stock exposure in international issues, but less than half of it is currency hedged.
In addition, Wells doesn’t view currency hedging as a permanent feature of the portfolios she manages. “If I thought I was in a strong cycle of dollar depreciation, I wouldn’t have any hedge,” she says.
“One has to take a somewhat tactical approach,” agrees Mark Luschini, chief investment strategist at Janney Montgomery Scott. He also favors the ETF format for currency-hedged foreign investments. “We’ve used hedges where we can,” he says, including the WisdomTree Japan Hedged Equity ETF (DXJ), which Luschini has owned for his clients for several years.
Until recently, he says, much of the hedged ETF product covering Europe was broad based. As a consequence, Janney has bought both hedged and unhedged European equity products for its clients.
A ‘SECOND DETERMINANT’
Luschini says his firm turned bullish on Europe more than a year and a half ago because many markets there appeared to be priced much cheaper than warranted. He stresses that the analysis of the opportunity comes first, then the hedging consideration. “It’s sort of the ‘second determinant,’ ” he says.
While a secondary consideration for Luschini, Wander eschews currency hedging whenever possible. This despite experiences like last year’s overseas gains turning into losses. He cites the additional cost and his perception, supported by the Morningstar study, that fluctuations tend to even out over long periods of time.
He is not alone in avoiding hedging strategies. “We don’t do any currency hedging,” reports Hugh Smith, chief investment officer at the Welch Group in Birmingham, Ala. “If I had a short-term investment mind-set, hedging currency risk might make sense.”
Smith sees foreign equity investments as a portfolio diversifier, adding that he wants the currency risk “as part of that diversification.”
Welch’s equity strategy is centered on individual dividend-paying stocks that Smith and his team select for clients. Most of the holdings are multinational corporations that have significant operations overseas. “There may be some currency hedging that those companies are doing,” Smith says, “but we’re allowing management of those companies to make those decisions.”
Some 48% of the sales for the S&P 500 companies came from outside the U.S. last year. “Coca-Cola is the classic example,” Wander says. “They’re based in the U.S., but more than 80% of their operating profits are overseas.”
Although the question of currency hedging appears to be binary, there may be a third choice. Randy Swan, president and CEO of Swan Global Investments, believes that you don’t have to hedge currencies to protect emerging market investments from a rising dollar. Swan says that hedging the entire position generally protects U.S. investors from adverse currency effects because emerging markets and their currencies tend to rise and fall in tandem.
AN OPTIONS-BASED STRATEGY
Swan’s strategy, as expressed in his Swan Defined Risk Emerging Markets Fund (SDFAX), is to own an ETF of the underlying emerging markets and buy at- or near-the-money two-year put options on the fund. Long-term options are cheaper than short-term options on a daily basis and offer downside protection. He then generates income by selling short-term out-of-the-money puts and calls.
Is this a viable way to hedge currency exposure? Since SDFAX made its debut only at the end of 2014, advisors may have to wait for an answer.
In the meantime, few advisors are actually getting questions from clients about currency hedging. Instead, Wander says, he gets questions about Puerto Rico munis and Greek holdings. “I think clients tend to think more in terms of headline risk,” he adds.
Although the questions are not asked, any losses resulting from adverse currency moves nevertheless may weigh on clients. Even those who say they are long-term investors may wind up judging an advisor’s performance on a short-term basis. Whether an advisor uses hedged ETFs or not, it pays to explain the strategy and the reason behind it to the people whose assets you manage.
As Wells puts it: Think of the discussion as a hedge against the potential loss of your client.
Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor’s weekly investment advisory newsletter, The Outlook.