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Do currency-hedged ETFs give better returns at lower risk?

A new report sheds light on how investors should be using currency hedging to improve portfolio returns
June 17, 2015

Overseas equities can be healthy sources of return, but exposure to foreign currency can take a serious toll on those returns. For that reason, exchange-traded funds (ETFs) that are hedged to sterling are growing in popularity. But just how much difference has hedging made to portfolio returns?

Why hedge?

The launch of quantitative easing programmes in Europe and Japan and Switzerland's dramatic decision to unpeg the franc from the euro in January this year has increased the volatility of foreign exchange markets and made investing in overseas equities trickier.

Vincent Denoiseux, ETF strategist at Deutsche Asset & Wealth Management, says: "Foreign currencies can be a significant driver of risk and return in a portfolio", particularly in the short to medium term. In a new report analysing the impact of currency hedging on the performance and volatility of various indices, he says "the periodic drawdowns experienced by an unhedged investor can be severe, even when holding a notionally strong currency".

But is hedging the answer? Mr Denoiseux says that if you see 'hedged' within a fund's name you would expect that fund to be less risky. So his team compared hedged and unhedged indices for equities and fixed-income products to see whether hedging really was best, both when it came to risk and return.

  

Unhedged versus hedged index returns

The clearest cases for opting for currency-hedged ETFs are in Japan and Europe, where sterling-hedged indices have returned more than their unhedged counterparts on a one- and five-year annualised basis.

The hedged versions of the MSCI EMU and MSCI Japan indices both beat their unhedged counterpart indices by significant margins over one and five years.

  

Annualised performance % of hedged and unhedged indices in GBP base currencies

UnhedgedHedgedUnhedged Hedged
1-year annualised5-year annualised
MSCI World19.114.010.511.1
MSCI EMU-6.120.64.510.0
S&P 50025.812.014.213.4
MSCI Japan 25.830.26.310.3
Barclays Global Agg8.27.82.84.9

Source: Deutsche Bank Asset & Wealth Management

  

Investors in the UBS ETF MSCI EMU 100 % hedged to GBP UCITS ETF (UC60) fared much better than those invested in the unhedged UBS ETF MSCI EMU UCITS ETF (EUR) Dis (UB06) over six months and one year. The rapidly weakening euro at the start of the year meant that those not invested in a hedged share class saw performance hit by the devalued currency.

The same is true of Japanese ETFs from iShares and UBS, with iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) outperforming iShares MSCI Japan Acc GBP (CSJP) over one year and UBS ETF MSCI Japan 100% hedged to GBP UCITS ETF (GBP) (UC61) outperforming UBS ETF MSCI Japan GBP (UB02) over one, three, six months and a year.

  

Cumulative performance % of UBS hedged and unhedged EMU ETFs

1 month3 months6 months1 year
UBS ETF MSCI EMU 100% hedged to GBP UCITs ETF (GBP) (UC60)-3.6-1.313.910.4
UBS ETF - MSCI EMU UCITS ETF (EUR) -Dis (GBP) (UB06)-2.70.85.9-0.3

  

Cumulative performance % of Japanese hedged and unhedged ETFs

JAPAN 1 month3 months6 months1 year
iShares MSCI Japan GBP Hedged UCITs ETFIPJH4.38.815.534.8
iShares MSCI Japan Acc GBPCSJP0.74.212.922.3
UBS ETF MSCI Japan 100% hedged to GBP UCITS ETF (GBP) UC614.38.915.535.0
UBS ETF MSCI Japan GBP UB020.74.112.822.3

Source: FE Trustnet, as at 10 June 2015

  

Remember also that just as you can avoid hits from a depreciating currency, with a hedged share class you will miss out if the currency you invest in appreciates against your own. For investors in MSCI World products or the US a strong dollar has handed gains to unhedged ETFs.

Over the long term it will be harder to predict which way currency trends will move and it might be best to avoid hedging altogether if invested for the very long term. Mr Denoiseux says: "The longer the time horizon, the greater the likelihood that the performance of hedged and unhedged indices converge."

  

Are hedged ETFs less volatile?

Some sterling-hedged equity ETFs might have delivered better returns than their unhedged counterparts, but that does not mean they offer a smoother ride. Mr Denoiseux says: "We looked at volatility ratios as a very straightforward way of checking on an asset class by asset class basis what happens if you hedge or not."

The report calculates the volatility reduction factor for several main indices. The factor is calculated as the ratio between the volatility of the hedged index in a particular currency and the unhedged index in the same currency. A number close to 100 per cent shows that there is very little difference between the two indices while a lower number shows a big difference in risk between them.

"For equity indices it's not black and white, but for fixed income the risk reduction with hedging is massive," says Mr Denoiseux. "The volatility of the FX rate is much higher than the volatility of the bonds themselves."

The MSCI World and MSCI Japan demonstrate very little difference in risk, while Barclays Global Aggregate, a broad fixed-income index, has a volatility reduction factor of 33 per cent for sterling hedging. That index also has a very low volatility ratio, at 2.33 per cent.

Mr Denoiseux says: "By comparison with a global equity portfolio (in which equity risk dominates currency risk), the contribution of currencies to the risk and return of a global bond portfolio is proportionately larger. As a result, the risk reduction achieved by currency hedging a global bond index is noticeably greater in relative terms."

So when it come to performance, it might well be worth currency hedging, but if it's lower volatility you want, currency-hedged equity ETFs aren't the route to take.

  

Five-year volatility comparison between hedged and unhedged indices

Index5-year volatility ratio*Volatility reduction factor (%)**
Hedged in GBPUnhedged in GBPGBP
MSCI World 13.213102
MSCI EMU19.824.979
S&P 50016.115.9101
MSCI Japan19.719.1103
Barclays Global Agg2.26.633

*Lower number = lower volatility

**Lower number = lower correlation between volatility of hedged and unhedged volatility