Currency Hedged ETFs: An Illustration of New Frontier's ETF Screening Process

By New Frontier

New Frontier’s GSAA funds attempt to capture every risk factor of the market that is available through exchange traded funds. Since their introduction in 1989-90, ETFs have proliferated and flourished as investment vehicles because of their attractive features of lower expense ratio, transparency, liquidity, tax structure, and stock-like trading. New ETFs are created continually, and New Frontier monitors them for good candidates to add to our Global Strategic Asset Allocation (GSAA) funds.

One hazard of international investing is the endemic currency risk, which has been notable recently due to fluctuations in several developing markets and a strong dollar. A series of ETF products has been introduced which attempts to mitigate the currency risk by pairing the underlying securities with derivatives. Naturally the marketing narratives for these products are quite enticing to global investors in current markets, so the products have been quite popular. At New Frontier, it is our duty to review new ETF products for potential inclusion in our portfolios. After our investigation of the currency hedged ETF offerings, we declined to introduce them into our global strategic fund, because we felt their risks made them unsuitable for strategic investing, and that the non-hedged products were better suited to our needs.

Below is a discussion from our research analyst, Dan Balter, revealing some more specific findings about these currency hedged ETFs.

Introduction 
Recently the US dollar has strengthened against many international currencies, and the appeal of currency hedged ETFs is on the rise. A currency hedged equity ETF invests in international markets while maintaining derivative exposure that favors a strengthening dollar. One of the ways currency hedged ETFs create the hedge is by using NDFs (non-deliverable forward contracts). When betting on the dollar to strengthen, NDF contracts are positive when the dollar strengthens and negative when the dollar weakens against the opposing international currency. While currency hedged ETFs perform well when the dollar strengthens, their structure poses risks for a global strategic investor.

Currency hedged equity ETFs are not the same as investing in local currency.
The hedging methods utilized to create the hedge must be reset at intervals (usually monthly). Because of this periodic forward roll of the forward contract, your currency bet is on the original amount at the beginning of the period, where a local position’s currency bet is on the current value of the securities in the portfolio. Comparing the two methods, a local position is more beneficial when the currency bet and securities values move in the same direction, whereas a hedged method works better when the currency bet and security value move in opposite directions. Most importantly to note it is possible, though unlikely, for a currency hedged ETF to go to zero (or negative) and this is not possible with a local or US Dollar denominated position.

currency hedge table

Although the actual value of the ETF shares will not go negative, the event in the right column will result in catastrophic loss for investors in the ETF.

A currency hedge is not an asset class. 
Currency movement is noisy and unpredictable. Moreover, it is unclear if a reliable US dollar premium exists.

Currency hedges turn positive and negative. 
While a currency hedge provides a nice return when the dollar is strengthening, when the currency tides change against the dollar the hedge loses and the hedge becomes negative.

From a strategic perspective, investing in international markets with a currency hedged ETF presents enough risks to outweigh the rewards of occasionally being correct on your currency bet. Currency returns are notoriously difficult to predict.

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