How to play currency hedging in Japan and Europe

Currency hedged share classes have developed as a way of neutralising the currency risk of an investment, designed to combat the hit you take by converting returns from a weak foreign currency back to sterling.

Europe could be the next boom in currency hedged share classes, with fund managers reportedly preparing new ranges in response to swelling demand. This follows a proliferation of Japanese currency hedged share classes. But has the argument for currency hedging all played out and is it worth the cost?

The Japanese story

Japan has recently been the strongest case for currency hedging, following the election of Prime Minister Shinzo Abe in 2012. The government weakened the yen with a policy of massive fiscal stimulus the following year in a bid to boost the country's competitiveness and freeing it from a quagmire of deflation.

By December 2014 the yen had fallen to a seven-year low against the dollar and had fallen 11.8 per cent against the pound since December 2013. Investors who had opted for the growing range of hedged share classes made hay while those in unhedged classes looked on as the pound conversion took chunks out of their returns.

Paul Taylor, managing director of McCarthy Taylor, says: "In 2013, Abenomics sent the yen down by about 19 per cent against pound sterling. As a result, while the MSCI Japan in yen gained 55 per cent that year, the iShares MSCI Japan UCITS ETF (CSJP) in pound sterling advanced by only 24 per cent. On the other hand, the iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) returned 52 per cent."

The case for European hedging

This year it was the turn of the euro, which began a rapid tumble in value following the much anticipated launch of a €1.1 trillion QE package by the European Central Bank in January. Two days after the announcement, the single currency weakened to its lowest point against sterling since 2007 and fell to a fresh 12-year low against the dollar, sliding below $1.06 for the first time since April 2003.

European equities rallied as a result of the stimulus programme, sending investors on the hunt for European funds. In particular investors have become keen on the idea of European hedged share classes but supply is low, prompting indecision among managers unsure of whether to take the plunge and launch new offerings.

Jason Hollands, managing director at Bestinvest says demand is forcing active managers to face up to the idea of launching new share classes but nervousness over the short-term nature of currency trading is leading to concerns that they could be left with empty funds when the trade turns sour.

The area has been much busier for exchange-traded fund (ETF) houses, which are more suited to the shorter-term trading patterns connected with currency flows. UBS is the largest provider of currency hedged ETFs in Europe.

Andrew Walsh, executive director of UK ETF sales at UBS says the fund house has seen major inflows into European hedged funds in recent months. Popular products include UBS MSCI EMU USD hedged ETF (UC89) and UBS MSCI EMU GBP hedged ETF (UC60).

Too late to the party?

But has this story already played out? Many say currency devaluation is over for now in Japan and that the difficulties of predicting currency fluctuations could mean that in a worst-case scenario you could forgo a potential currency upside as well as taking a hit from a drop in equity returns.

"So far this year, the Japanese yen, contrary to most fund manager's predictions, has actually strengthened and you would have been better off in the non-hedged than hedged product," says Alan Miller, chief founder of SCM Private. "Take the iShares Japan ETF; so far in 2015 you would have been better off in the non-hedged version of the fund."

All unhedged Japanese funds mentioned in this article have delivered better returns in the year to date than their hedged counterparts, implying that the stellar returns may be over, despite Mr Abe's re-election in December 2014.

Mr Taylor says he would still recommend hedging in Japan but many managers say currency hedging is something to steer clear of unless you feel you have a strong hunch over which way a currency will move, or are prepared to monitor your investment and make short-term trades. "The currency markets are very fickle and you’ve really got no idea what they're going to do from one minute to the next," says Ben Yearsley, head of investment research at Charles Stanley Direct.

That is particularly true of Europe now, where commentators are divided over the future of the euro. Lots of people are calling for European funds to be hedged which is fine if you think the euro is going to weaken further but if you consider the fact that you've already got down to 1.356 now and it was almost parity a few years ago, is it going to weaken much further? If it doesn't you'll have put a hedge on it and have paid 1 per cent for nothing," says Mr Yearsley. "There's also the chance that sterling might weaken ahead of the election and if that happens and you are in overseas assets, you make money on that."

Here too a bad currency bet could mean you lose twice, for example if equities fell and the currency appreciated you would both lose out on the currency gain and on the drop in returns.

Mr Miller says there tends to be an inverse relationship between currency appreciation and equity performance as cheaper currencies make exports more appealing. In his view that means you are likely to forego a downside protection afforded by an appreciating currency when returns from equities are falling if you are in a hedged share class. He says: "There is a natural hedge from investing in the foreign equities market in the local currency."

Nikkei vs yen/GBP exchange rate

However, this view is disputed by Lars Krekel, global equity strategist at Legal & General Investment Management. "In many ways FX is the unreliable boyfriend when it comes to analysis of equity performance. There are no easy rules to tell us whether a weak euro means European equities will go up or down," he says.

Perhaps the key issue is your investment horizon, with currency plays best suited to short-term investors. Darius Mr McDermott, managing director of Chelsea Financial Services, says: "If you're taking a medium to long-term view these things tend to mean revert. If you're investing for 10 years don't worry about currency because where there is QE in Europe there may be a good argument for hedging but it could quickly revert and how many people are going to be good enough at the timing?

"There was a stand-out trade in Japan, with the Prime Minister's stated aim to weaken the currency, you would be stupid to fight that. But with the euro, at the moment we have QE so I don't think you’d lose over the next 12 months but there is just no visibility on the long-term."

The lesson here? By all means hedge currency as a means of removing currency risk but if you look on it as a short-term trade to win big you are likely to be disappointed. Think of this as an insurance policy in which you must be prepared to forego upside when FX markets move - which they will, in unpredictable ways.

Currency hedged fund options for Europe and Japan

If you like the idea of neutralising European currency risk, Mr Hollands points to Artemis European Opportunities I Hedged (GB00B6WFCS60), which has delivered higher returns in the year to date than its unhedged share class (GB00B6WFCR53). Its aim is to generate long term growth through European equities outside the UK but it invests in a range of shares, fixed-interest securities and derivatives too.

Another option is JPM Europe Dynamic ex UK C Hedged Acc GBP (GB00BCV7MM92), available at an ongoing charge of 0.94 per cent. In one month the fund has returned 5.57 per cent compared to its unhedged share class (GB00B02L5M76), at 2.24 per cent.

UBS MSCI EMU 100% Hedged GBP ETF (UC60) comes broadly recommended for its low ongoing charge (0.33 per cent) and good exposure to the larger countries in the eurozone. It is available in accumulating and distributing share classes and it has outperformed its unhedged peer in both 2014 and 2015.

When it comes to Japan equities, which have a longer history, there are solid options in both active and passive funds. GLG Japan CoreAlpha Equities IH GBP (FX hedged) fund (IE00B64XDT64) is managed by Steven Harker and Neil Edwards, who also manage the GLG Japan CoreAlpha Retail fund (GB00B0119933), with the same underlying portfolio. However holders of the hedged fund took returns of 60.9 per cent in 2013 compared with 31.5 per cent for the unhedged option (IE00B64XDT64).

Schroder Tokyo Z Hedged Acc GBP (GB00B8BJDX53) is another slightly cheaper option, with an ongoing charge of 0.91 per cent. In 2014 it outperformed the Schroder Tokyo unhedged fund (GB00B4SZR818) and in 2014 also outperformed the GLG hedged fund.

There are two main passive options, which come with smaller price tags but are more costly than the average ETF due to the added cost of currency hedging. iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) returned 51.7 per cent in 2013 and beat GLG in 2014, returning 8.28 per cent compared to 7.4 per cent. It comes at a cost of 0.64 per cent (compared to 0.48 per cent for the iShares MSCI Japan UCITS ETF (Acc) (CSJP). There is also the cost of rolling forward contracts, which is typically done on a monthly basis.

Adam Laird, passive investment manager at Hargreaves Lansdown, likes db X-trackers MSCI Japan Index UCITS ETF (GBP hedged) (XMJG). It has a similar ongoing charge of 0.60 per cent and has delivered very similar results to IJPH.

Performance (total return %) of recommended European funds (hedged and unhedged)

Source: FE Analytics, as at 1 April 2015

Performance (total return %) of recommended Japan funds (hedged and unhedged)

Source: FE Analytics, as at 1 April 2015