Getting true passive international exposure
Using inexpensive passive strategies for international equity exposure has gained plenty of traction as the popularity of ETFs has grown across the board. There are still plenty of active managers worth the added expense, but like many other asset classes, there are times when an active approach is in favor relative to a passive benchmark, and vice versa.
Similar to the decision between active vs. passive, the choice also exists for investors within passive strategies to include or remove exposures to the foreign currencies through unhedged and hedged strategies, respectively. While choosing the lowest cost option may feel like the “most passive” solution, investors should take note that choosing a strategy that does not hedge foreign currencies is essentially making an active decision to partake in the returns of the foreign currency vs. the domestic currency (USD). This can significantly increase the volatility of a foreign equity investment and can potentially result in negative total returns even when the portfolio of local equities rises in value.
In that case, why not remove the currency exposure all together? Doing this may harm the investor in the opposite situation where the portfolio of local equities falls in value and is offset by an appreciation in the currencies, bringing the total return to a positive number. Or, currency movements can compound a loss on top of an equity loss.
Whether an investor chooses not to hedge currencies or to fully hedge currencies, they are making a currency bet one way or another.
Timing currencies is a losing game
There is no lack of opinion on the direction of currencies for many reasons, a few of them being economic pressures, central bank views, and geopolitical concerns. Unfortunately, for every opinion on strength, an opinion on weakness is so close you can often find it in the same article!
While companies can theoretically grow indefinitely, the strength of one currency compared to another historically mean reverts, or gravitates back to an average. Therefore, deciding whether to have currency exposure or not based on past performance is, in our view, likely the worst thing an investor can do. And in practice, it’s often very difficult to tactically and efficiently manage currency exposure within an investor’s portfolio.
Case in point: Figure 1 shows the rolling 3-month advantage that currency hedging provides on an international index, along with the monthly net flows of money into and out of currency hedged ETFs. It seems that after hedged outperforms unhedged, the money chases the relative outperformance only to suffer a relative underperformance, and vice versa.
Figure 1: Flows in currency hedged ETFs tend to be poorly timed, often coming in after significant outperformance and going out prior to stronger performance vs. unhedged ETFs.
Monthly flows chasing 3-month Index performance
Source: Morningstar, 3/1/14-12/1/19 Past performance is not indicative of future results. An investment cannot be made in an index. Flows are represented on the right axis in $Billions, and include the cumulative monthly net flows of all existing Foreign Large Blend Passive Currency Hedged Index ETFs that existed at the time. The 3 Month Hedged Advantage refers to the relative 3 month trailing rolling performance of the MSCI EAFE Currency Hedged Net Return USD Index to the MSCI EAFE Net Return USD Index (Unhedged).
In fact, during this same time period, an investor’s annualized return in currency hedged international ETFs adjusted for net flows was -0.21%, while the MSCI EAFE 100% Hedged Index returned +6.13. In other words, going in and out of the hedged product cost investors 6.34% annually because of mistiming currency moves.
So, how can investors avoid the guessing game of currency movements but still reap the benefits of hedging? One option to consider is a truly passive 50% currency hedge. With this approach, timing the relative position of currencies to each other is unnecessary as the investor can potentially participate in foreign currency appreciation and manage downside exposure to the same extent. This passive buy and hold approach also can be more tax efficient compared to transacting between a hedged and unhedged fund (or rebalancing a pair) each containing the same underlying equities.
Below is a visual representation of how often the shift between hedged and unhedged foreign equity exposure can vary:
Figure 2: Rolling 6 month relative performance of Fully Hedged and Unhedged MSCI EAFE Index returns relative to the FTSE Developed ex North America 50% Hedged Index.
Hedged and unhedged relative to 50% hedged
Source: MSCI, FTSE, IndexIQ, 6/1/2005 – 12/1/2019. Past performance is not indicative of future results. An investment cannot be made in an index.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Hedged: A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.
MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
MSCI EAFE Currency Hedged Index represents a close estimation of the performance that can be achieved by hedging the currency exposures of its parent index, the MSCI EAFE Index, to the USD, the “home” currency for the hedged index.
FTSE Developed ex North America 50% Hedged Index: The Index is an equity benchmark of international stocks from developed markets outside of the U.S. & Canada, with approximately half of the currency exposure of the securities included in the Index “hedged” against the U.S. dollar on a monthly basis.
Active Management focuses on outperforming the market compared to a specific benchmark and therefore includes the risk of security selection that could result in the unintended outcome of relatively underperforming the benchmark. The security selection for actively managed portfolios involves employing a Portfolio Manager, and often additional resources, that typically results in higher fees to the investor.
“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.