Adding exposure to overseas assets might improve your portfolio's returns while lowering volatility.
However when you gain exposure to assets located outside of the UK, you also introduce currency risk.
To understand how currency is relevant to your ETF investments, you need to know the currency in which an ETF is priced and traded in and the currency exposure you are taking on via its underlying holdings.
You can then decide whether it's appropriate to use a currency hedged ETF to reduce or remove currency risk from your investment.
Currency riskCurrency risk is the possibility of the currency of the country you're investing in falling or rising compared to your own.
For instance, if you own European shares and the Euro falls versus the pound, then the value of your European shares will diminish in pound terms.
Exchange rate impact on a Euro investment
Note that it's the currency in which the underlying assets are ultimately priced that determines your currency risk.
Let's say you're a UK investor who buys an ETF listed on a European exchange valued in Euros that tracks the Japanese Nikkei index.
The exchange rate that determines your currency risk is the pound versus the Yen, not the pound versus the Euro or the Euro versus the Yen.
Fund denominationWhere things can get confusing with ETFs is that there are three different currencies to know about, even when simply trading on the London Stock Exchange.
The currency in which the ETF reports the value of its net assets. This currency is usually based on the index currency and is also known as denominated currency or base currency.
2. Trading currency
The currency in which an ETF can be bought or sold on a particular exchange.
3. Underlying currency
The currency the assets tracked by the ETF are predominantly valued in. If you own an ETF tracking the US S&P 500 stock market index then the underlying currency is the dollar. This is the currency which relevant to determine the currency risk of your investment.
For instance, the Amundi ETF MSCI USA ETF EUR tracks the MSCI US total return index. Its fund currency is the Euro, it's traded in pounds, and the underlying currency is the dollar.
Providers sometimes even offer the same ETF in different fund currencies. For instance, the Amundi ETF also comes in a dollar-denominated form.
The important point is that it's only the underlying currency that determines your currency risk, not the fund currency. So the fund currency and trading currency can be viewed as accounting currencies.
Currency hedged ETFsAdding exposure to different underlying currencies alters the diversification of your portfolio, although the outcome varies over different time periods and between asset classes.
Some investors argue they are investing overseas for the diversification afforded by, say, adding exposure to equities listed on a foreign market. They don’t need or want the currency fluctuations on top.
To remove currency risk, you can invest using a currency hedged ETF that tracks your desired index.
Here the fluctuations in the underlying currency are offset, so you're only exposed to the performance of the assets.
The db x-trackers MSCI Japan Index ETF tracks the 320 leading stocks on the Japanese market, as determined by the MSCI Japan index. The value of your investment will fluctuate with the index AND with the pound/Yen exchange rate.
Alternatively, you could buy the hedged version of the same ETF. This ETF is currency hedged to the pound, so your investment will ONLY fluctuate with the index (ignoring small tracking errors).
In order to see the impact of hedging, you can compare the returns achieved over a particular time period by a hedged versus an unhedged version of the same ETF.
One will have done better than the other, depending on how the exchange rate played out.
Hedged vs unhedged MSCI Japan investment
Source: justETF.com; As of 31/08/2015
Hedged MSCI Japan ETFs; Unhedged MSCI Japan ETFs
Ups and downs of hedgingHedged ETFs are increasing in popularity, but hedging does cost money, and this may result in higher expenses.
In the case of those two Japanese ETFs just discussed, the unhedged ETF costs 0.5%, compared to 0.6% for the hedged product.
There can also be indirect costs related to imperfect hedging, reflected in a greater tracking error. To reduce this the ETF provider may apply hedging daily as opposed to monthly; but this again may increase your costs.
Conclusion: ETFs give ready access to currency hedgingThe impact of currencies is complex. The fund currency, which is reported in your brokerage account, may be misleading. The currency risk is determined by the underlying currencies of the securities in the tracked index.
Currency risk introduces opportunity and risk at the same time. As an UK investor your assets win with a depreciation of the pound and lose with an appreciation of the pound against the foreign currency.
If you want to minimize the impact of currencies in your portfolio, you can use currency hedged ETFs.
When searching for currency-hedged ETFs you can use justETF Screener. If an ETF involves currency hedging, you will find the addition “Hedged” in the column fund currency. This indicates that the ETF hedges the associated currency risk into the fund currency.
The list of currency hedged ETFs is growing every year. Below is a list of GBP-hedged equity ETFs that are currently available.
Selection of GBP-hedged equity ETFs
in m GBP
|EURO STOXX® 50||Europe||19||27,585||-1.13%|
|MSCI EMU (GBP Hedged)||Europe||1||6||-0.93%|
|MSCI Europe ex UK||Europe||1||1,545||0.48%|
|MSCI USA||United States||11||7,400||0.61%|
|S&P 500®||United States||13||33,799||0.42%|
|S&P 500® (GBP Hedged)||United States||1||245||1.73%|