Supercharging global ETF returns
Getting the direction of currency right can boost returns, but understand the risks.
Exchange-traded funds (ETFs) have revolutionised how Australian investors access international markets. A few simple trades on ASX gives diversified exposure to hundreds of international stocks and bonds, tracking recognised benchmarks in liquid, low-cost packages.
However, apart from taking a view on international markets and asset classes, investing overseas also means taking a view on currency exposure. It is important to consider the impact of currency when using international ETFs.
(Editor’s note: Learn about the basics of exchange traded products with the free ASX online course on exchange traded funds and exchange traded commodities.)
How does currency affect international investments?
The easiest way to conceptualise currency exposure is to say that if you hold an exposure to US stocks, you are also exposed to the currency they are denominated in. All other things being equal, if the Australian dollar falls against the US dollar, your US-dollar investment is worth more. Conversely, if the Australian dollar goes up, the value of your US stocks falls.
For example, in 2015 the S&P 500, an index of the 500 largest US stocks by market capitalisation, was essentially flat for the year; gaining in the first half, experiencing major losses in August-September and recovering ground by year’s end. Over the same period, the Australian dollar fell against the US dollar by about 11 per cent.
Investors in the iShares Core S&P 500 ETF gained about 11 per cent for the year, not taking dividends into account. Given that the fund’s underlying stocks did not experience gains for the year, the positive returns were entirely driven by the Australian dollar’s depreciation.
Source: Bloomberg, BlackRock at 31 December, 2015. Cumulative returns rebased to $100 for illustrative purposes. Distributions not reinvested in return calculation.
However, the converse effect can also apply, and an appreciating Australian dollar can also wipe out any gains or exacerbate any losses on the underlying exposure to overseas stocks.
What is my exposure if I invest in international ETFs?
The ETF’s currency exposure is that of the underlying stocks or bonds that it holds. In the case of an ETF holding stocks listed in various countries, it will be exposed to the various currencies of the stocks.
For example, the iShares Global 100 ETF provides exposure to 100 of the world’s largest stocks by market capitalisation. As such, it is exposed to the movements of the Australian dollar against the US dollar, euro, British pound, Swiss franc, Japanese yen, Swedish krona and Korean won.
The exposure is proportional to the holding. That is, given that approximately 60 per cent of the market capitalisation of that portfolio is invested in US companies, 60 per cent of its currency exposure comes from the movements of the Australian dollar against the US dollar. The overall currency exposure is the net effect of the Australian dollar’s movements against the list of currencies.
How can I control the impact of currency on my investments?
Currency-hedged ETFs aim to provide the return of the international market benchmarks they track, while seeking to minimise the impact of the movement of the investor’s home currency against that of the overseas market(s).
The purpose of these funds is to enable investors to have access to international exposures, while reducing concerns about the Australian currency’s volatility. They provide a way to help manage the impact of currency movements on foreign investments, or take tactical views based on exchange rate expectations.
The difference between hedged and unhedged international ETFs is that the hedged ETF seeks to minimise the impact of the currency movement on the ETF’s return.
So in line with the earlier example, as the iShares S&P 500 AUD Hedged ETF seeks to hedge its US dollar exposure back to Australian dollars, the fund was flat for calendar year 2015 in terms of price return (not including dividends).
The unhedged equivalent, the iShares Core S&P 500 ETF, gained because of the depreciation of the Australian dollar against the US dollar over the same period. If the Australian dollar had appreciated against the US dollar, the hedged ETF would have performed better than the unhedged one.
How do they work?
Currency-hedged ETFs typically seek to minimise currency exposure by buying foreign currency forward contracts that are designed to offset the value of the currency exposure. That is, when there is a currency-based loss on the underlying ETF holdings, there is an equivalent gain on the forward contract and vice versa.
This approach is designed to minimise currency exposure, but it does not necessarily eliminate it. The return of the foreign currency forward contracts may not perfectly offset the actual fluctuations between the Australian dollar and the currencies the hedged ETF is exposed to.
To hedge or not to hedge?
There are different views on what is the best approach to currency hedging in portfolio construction. There is no universally applicable approach, and arguably the appropriate hedging ratio will vary over time and depend on a number of factors.
The beauty of ETFs as investment vehicles is they provide the simplicity and liquidity to adjust hedging positions with ease as conditions change. To increase a hedged position, the investor simply sells units of the unhedged ETF and buys the hedged version, and vice versa.
It could be said that in the short to medium term, if an investor has a high degree of conviction in relation to the direction and volatility of the currency, they could stand to benefit by taking tactical positions.
For example, in the chart below, a more hedged approach would have benefited an investor with exposure to the S&P 500 in years 2009 and 2010. However, in 2013 to 2015 an unhedged approach would have been more profitable, with the Australian dollar falling significantly.
Source: S&P Dow Jones Indices, BlackRock, 11 March, 2016.
In the long run it is harder to say there is an optimal level of currency hedging, as it is difficult to systematically forecast currency movements and volatility. Some investors, who may not be actively monitoring currency movements and adjusting their portfolios, may take the approach of adopting a balanced 50/50 hedged/unhedged allocation.
However, even with a straightforward asset allocation, it is important that investors regularly rebalance their portfolios to ensure that they stay aligned to their goals.
The Australian sharemarket represents less than 3 per cent of global shares by market capitalisation and is heavily concentrated in financials, so it is natural for Australian investors to add offshore exposure to build better diversified portfolios.
Seeking international exposure implicitly means taking on currency risk. Taking a considered and deliberate approach to currency hedging can have a meaningful impact on returns in the short to medium term.
About the author
Jonathan Howie is Director and Head of iShares Australia. He is responsible for the management and development of the iShares exchange traded fund (ETF) business in Australia. iShares has the largest range of ETFs quoted on ASX (31 funds) and more than 700 funds globally (as at February 28, 2016). iShares ETFs are powered by the portfolio and risk management of BlackRock, which manages more money than any other investment firm (as at 31 December 2015, based on US$4.645 trillion of assets under management). iShares offers five currency hedged ETFs on ASX, including exposure to US and global equities, global corporate, high yield and emerging market bonds. For further information click here.
Jonathan Howie is Director and Head of iShares Australia. He is responsible for the management and development of the iShares exchange traded fund (ETF) business in Australia.
iShares has the largest range of ETFs quoted on ASX (31 funds) and more than 700 funds globally (as at February 28, 2016). iShares ETFs are powered by the portfolio and risk management of BlackRock, which manages more money than any other investment firm (as at 31 December 2015, based on US$4.645 trillion of assets under management).
iShares offers five currency hedged ETFs on ASX, including exposure to US and global equities, global corporate, high yield and emerging market bonds. For further information click here.
Exchange Traded Products has information on the features, benefits and risks of ASX-listed ETPs.