The recent Greek debt crisis is a perfect example of why a currency-hedged exchange-traded fund (ETF) can offer investors a targeted solution and isolate unwarranted risks.
ETFs offer the simplicity of a currency-hedged overlay on top of investors’ foreign equity exposure in one simple trade.
A key consideration for investors should be the uncertainty surrounding the future value of the euro when investing in European equity markets.
In spite of the dust finally settling over the Greek crisis, the potential political and economic repercussions on financial markets of a repeat crisis remain too great to be ignored. Containing such risk can be made possible through currency-hedged ETFs, which have grown in popularity in recent years on the back of diverging monetary policies in developed markets.
With the US Federal Reserve reaffirming its intention to tighten monetary policy and preparing its first rate hike in almost 10 years, both the European Central Bank (ECB) and the Bank of Japan (BoJ) remain committed to large-scale asset purchases – quantitative easing (QE) – to complement their near-zero interest rate policies. This has all but exhausted the levers at their disposal to employ further monetary easing.
Such contrasting monetary policies will exert downward pressure on the euro and the yen, compelling foreign investors seeking exposure to European and Japanese equities to hedge themselves against devaluation risk.
However, the viability of currency-hedged strategies should not be seen through the lens of having to have a view on currencies per se. Consider the euro-dollar exchange rate, currently hovering around $1.10 to €1.00. With or without Greece, and with or without Fed monetary tightening, what’s the euro really worth?
This uncertainty surrounding the euro in spite of its recent resilience has not gone away and, if anything, has merely grown. The implied volatility of the euro-dollar exchange rate has risen to levels well above those seen during the “whatever-it-takes”-to-save-the-euro speech by Mario Draghi from July 2012.
Irrespective of what direction the value of the currency moves, investors seeking exposure to international equities tend not to have a view on the euro. The reason for this is mainly due to complexity.
While the price of equities is derived from the discounted dividend stream and anchors around earnings growth expectations, a currency’s exchange rate is a fundamental assessment of the relative attractiveness of two economies’ income-generating asset classes.
While the interest rate differential between two economies is often a good proxy for a currency’s relative strength, in reality it is the expected return of all major asset classes, including equities, bank deposits, fixed income and real estate, which together drive currency trends. Add in the intertwining driving forces of two economies’ monetary policies, capital flows and the political sentiment, and the assessment of currency valuations becomes inherently complex.
The argument for a currency-hedged strategy is reinforced by the relatively low cost of currency hedging, especially in the current suppressed interest-rate environment in developed markets. In a weak economy such as the eurozone where growth is largely driven by the external account, foreign investors who bought into the region’s export stocks have the benefit of borrowing euros relatively cheaply and then selling the euro forward for their home currency to lock in the exchange rate at a future date.
