Dossier ETFs and ETPs
Benefits and disadvantages of hedging exchange rate risks
Around 10 percent of all ETFs are now offered in a variant with currency hedging. The aim is to fade out exchange rate fluctuations. How useful this is depends on the asset class, the region and the time horizon, among other things.
A key advantage of ETFs is their low-cost and low risk diversification. With one share, investors invest in many different securities. A handful of index trackers already enable a broadly diversified portfolio invested in different asset classes and many sub asset classes. With the aim of being prepared against future crises.
The side effects of such a well-balanced portfolio: entire asset classes in foreign currencies, mainly US dollars, such as commodities or precious metals. And if you want to avoid cluster risks through investments, especially in your home country, there is no way around international equities in the respective local currency. The MSCI World, which is particularly popular with private investors, contains equities in 13 currencies and the MSCI World All Countries in about 20.
Securities that are traded in a different currency carry an additional risk. For this reason, issuers also offer a currency-hedged variant for many ETFs. Of a total of more than 1,500 ETFs traded on Xetra, 142 (around one-tenth) are equipped with a mechanism designed to eliminate exchange rate fluctuations wherever possible.
- Local currency. Currency in which investors calculate the majority of their income and expenditure
- Basic currency. Currency of the securities in the ETF. If the base currency differs from the local currency, a currency risk arises.
- Fund currency. Currency in which ETF providers settle accounts.
- Trading currency. Currency in which the ETF is traded on the exchange. On Xetra, for a small number of ETFs this is not the euro, but pounds sterling, US dollars, Swiss francs, etc.
The important question for investors at this point: What does the hedge protect and what price do investors pay?
Important for the evaluation of currency risks is the "home currency" of the investors, in which currency area their life center is located, their income and their expenditures. If the securities in the ETF are traded in a different currency, the exchange rate can have a negative (but also positive) effect on the return. Regardless of the fund currency, which only indicates the currency in which an ETF issuer reports, i.e. where the conversion takes place. The trading currency of the ETF itself also plays no role in this risk from the investors' point of view.
Toetzke
If the trading currencies of the securities differ from the investors' home currency, a currency risk arises. Foreign currencies are an independently uncorrelated asset class. They distort the actual performance of the securities in the ETF. If, for example, the price of gold rises by 10 percent and the US dollar falls by 10 percent at the same time, the bottom line in euros is zero.
Eliminate risks by default
ETFs where this unwanted effect is to be neutralized can often be recognized by the name containing the hedged currency with the addition "hedged".
Individual pairs of exchange rates are hedged, such as the euro against the US dollar, or several so-called multi-currency hedges. The latter are rarer and usually relate to regions such as emerging markets or a specific global equity segment, e.g. small caps.
How does a currency hedge work?
On a certain key date, usually monthly, very rarely daily, providers enter into a foreign exchange transaction on the futures market, a forward, with which they hedge the assets under management at that time for one month. However, the forward exchange rate differs from the current spot rate by the difference in interest rates between the two currencies.
Currency hedging in an ETF cannot be accurate for two reasons:
The timing. Only the managed assets can be hedged on a specific date. Inflows and outflows within the month are not subsequently corrected in the hedge.
The protection. It is not possible to hedge the spot exchange rate, but only the forward rate, which differs by interest rate differences. If the foreign currency has a higher interest rate than the own currency, this interest rate difference is at the expense of the investors. Since interest rates in emerging markets are much higher than in industrialized countries, these currency-hedged ETFs from this component have higher losses compared to the unhedged versions.
Vogt
Expectations regarding exchange rate developments count
At least in the short to medium term, a currency-hedged ETF can be advantageous. If the own currency wins, the currency loss without hedge performance costs. However, in the opposite case, if your own currency loses against the currency in the ETF, the return for investors increases due to the currency gain. What a hedged ETF misses.
In the long term, the currencies of the industrial nations follow the "mean reversion". This means that they fluctuate around a mean value in structurally stable times. This means that investors are winners and losers at times, and hedging incurs costs without any real long-term benefit.
These costs are not insignificant; many secured ETF classes have higher total costs, on average about 0.3 to 0.4 percent. In addition, parts of the hedge costs could lead to a negative tracking difference compared to the index. Both of these factors are increasingly impacting performance, especially in the case of very long-term commitments.
More exotic currencies are more susceptible to long-term devaluations against key currencies such as the euro. In these cases, however, the costs of hedging are also significantly higher because higher forward premiums have to be paid.
The sense or nonsense of a currency hedge depends on the long-term exchange rate expectations of investors, whether they expect their home currency to rise or fall or whether they have no opinion.
Here are two further considerations:
Although shares of large corporations are traded in only one currency, their business results interact with regional markets and their respective national currencies via the supply and sales chains.
The value of a currency and the success of the companies in the country are related to each other, so that the exchange rates also have an indirect impact on the stock markets via the company results.
Conclusion
The choice between currency-hedged and non-hedged versions of the same ETF enables experienced ETF investors to actively integrate the currency component into their portfolio management. However, this is only possible within tactical asset allocation as an additional income component. Long-term oriented investors buy the elimination of short-term fluctuations with not inconsiderable performance losses.
With one exception: Those who invest in international government bonds to stabilize their portfolio in ETFs probably like to exchange yield points for volatility in the portfolio.
From Stefan Toetzke and Edda Vogt
© November 2020, Deutsche Börse AG
Deutsche Börse 
