When investing in exchange traded funds (ETFs) in overseas markets, aside from the risk of losing your capital if the market in which you invest performs poorly, you face three other additional risks. These are the additional risks of capital loss from unfavourable fluctuations in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.
To deal with the fluctuations in currency values risk, over the past year a whole raft of products have launched that allow UK investors to invest in a market, for example Japanese stocks, while getting rid of a risk in the trade that they don't want, such as exposure to the yen. These products can mostly be identified by "GBP hedged" in the ETF name.
But for investors wanting to keep things as simple as possible, are these hedged ETFs appropriate? And have you the time to monitor the currency exposure in addition to market risk? Or should you look at switching between mirror ETF products that hedge or don't hedge the currency risk, in order to give you an advantage?
Christopher Aldous, managing director of Charles Stanley Pan-Asset Capital Management, says: "There used to be a dearth of currency hedged products. But UBS has brought in a whole range of hedged products. Vanguard have also come out with a currency hedge." iShares and db x-trackers have also launched currency hedged ETFs within recent years.
Most ETFs have a base currency of US dollars. This means an investment in an unhedged foreign equity ETF is for investors with a bullish outlook on foreign markets, but it is also effectively a short US dollar trade, because a strengthening dollar would reduce the returns of the ETF. Conversely, if the dollar depreciates against the underlying foreign currency, the unhedged ETF would outperform its hedged peer. Currency hedged ETFs attempt to match the local currency performance of the underlying index, which makes them particularly attractive to investors who expect the dollar to continue to strengthen.
Why hedge?
Proponents of hedging argue that with the growth of global investing, the impact of currency movements can be a significant issue. Investors are exposed to currency risk when investing abroad and adverse moves in exchange rates can impact their performance. It can help boost your short-term returns, if you get the hedge right. Mr Aldous explains: "Investing overseas is a good inflation hedge. From 2008 onwards holding overseas equities was good. Sterling weakened and you made nice currency returns. However, if you factor in a potential change of UK government next year, which might mean more public spending and a weaker currency, you might lose 10 per cent on the currency."
In this week's reader portfolio our reader, Anand, is holding the iShares MSCI World GBP Hedged ETF (IGWD) in his portfolio. However, expert Alan Miller, chief investment officer at SCM Private, said: "Sterling has been increasingly strong over the last 12 months. So I would rather have an unhedged MSCI World ETF than a hedged World ETF."
Over the past three years the hedged version, (IGWD), has done better, delivering a 34.89 per cent return to investors, compared with a 32.71 per cent return from the unhedged version of the ETF, SWDA, whose base currency is US dollars. That's a 2.18 per cent difference in performance. It might not seem like much over three years, but if you are investing over 30 years and can get your currency calls right, then could this be a 21.8 per cent difference in returns? That sounds attractive - unless you get your currency calls wrong and lose an equivalent amount. If the stocks in your chosen market decline, but the currency rises against sterling for an extended period, you would have a double blow to your holdings.
| Product performance (%) | Year to 26 March 2014 | Year to 26 March 2013 | Year to 26 March 2012 |
| iShares MSCI World UCITS ETF Acc (SWDA) | 17.78 | 10.48 | 1.99 |
| iShares MSCI World GBP Hedged UCITS ETF (IGWD) | 16.89 | 12.6 | 2.48 |
Source: iShares product factsheets
Why not hedge?
It's nigh on impossible for most investors to predict currency trends. Mr Aldous says: "The factors which make currencies move are far from obvious."
Investors should also be aware that the currency hedge adds an extra layer of risk to your portfolio. When an ETF invests in forward foreign currency contracts or uses other investments to hedge against currency risks, it will be subject to extra risks - for example, counterparty risk, which is the risk that the other party in the transaction will not fulfil its contractual obligation.
iShares also warns in its product literature: "Increased volatility will generally reduce the effectiveness of a fund's currency hedging strategy. While hedging can reduce or eliminate losses, it can also reduce or eliminate gains."
There is another risk that the ETF provider's currency hedging strategy will not necessarily eliminate the fund's exposure to the component currencies and there can be no assurance that a fund's hedging transactions will be effective.
Mr Aldous says: "Over a one-year view, currency is critical. But I'd probably take a view that currency risk over the long term is something you can ignore."
