ANALYSIS-Forex hedging in vogue as U.S. investors target overseas shares
NEW YORK, Aug 7 (Reuters) - U.S. investors who buy foreign stocks are increasingly looking at currency hedging, a strategy that has had a mixed track record.
There are nearly 1,500 exchange-traded funds, but the one with the greatest inflows so far in 2013 has been the WisdomTree Japan Hedged Equity Fund. It has had more than $9 billion in inflows, equivalent to 82 percent of its total assets, according to ETF industry tracker IndexUniverse.
Several other hedged ETFs geared toward offsetting the effects of foreign currency fluctuation have been introduced this year or are in the process of being rolled out, though they are smaller than DXJ.
That is new for the stock market.
Large fund managers, particularly in fixed income, have long hedged against currency volatility. But equity markets were already volatile, and the additional cost of managing currency risk was one that has not necessarily proved effective - tending to reduce returns even though it tamps down volatility.
Evidence on the benefits of hedging in stocks has been weak.
The real return for a U.S. investor in 19 countries between 1972 and 2011 was 6.1 percent unhedged, or 4.7 percent hedged, according to a recent study by Credit Suisse and the London Business School. The hedge reduced volatility by 2.7 percent, but at the cost of a 1.4 percent reduction in the annualized real U.S. dollar return.
There are a number of reasons currency hedging strategies, including ETFs, are drawing interest this year. More investors are allocating assets to international markets. Also, fund managers believe some markets, Japan and the United Kingdom in particular, could have strong equity markets and weak currencies due to central-bank intervention, which makes an isolated bet on equity market performance more attractive.
"When one considers the relative inexpensiveness of hedging the currency risk of international portfolios against a rise in the U.S. dollar, it could prove to be good value for U.S.-based investors," said Vassilis Dagioglu, head of asset allocation portfolio management at Mellon Capital in San Francisco. Mellon Capital oversees about $300 billion in assets.
When the U.S. dollar rises, gains on securities denominated in foreign currencies are reduced when they are converted back into dollars.
For instance, the iShares MSCI Japan ETF, which does not hedge currency risks, is up 19 percent this year. That compares with a 24 percent rise in WisdomTree's hedged Japan ETF and a 28 percent gain in Deutsche's DB X-trackers MSCI Japan Hedged Equity Fund.
In recent months, three more hedged equity ETFs have been rolled out by WisdomTree and Deutsche Bank, bringing the number of such funds to at least nine, with total assets of about $11 billion, up from $1.3 billion at the end of last year. That's not much, admittedly - but it's a start.
ETFs are marketed to retail investors but are more frequently used by institutions for short-term bets or hedges. Investors can now hedge foreign stock exposure in markets such as Germany, the UK, Brazil and other emerging economies.
Deutsche has filed paperwork for another three hedged ETFs, and MSCI, a provider of widely tracked stock indexes, has indexes catering to investors who want to hedge currency risks on a daily basis, instead of monthly.
The costs of ETFs vary and depend on the fund sponsor. WisdomTree's Japan hedged ETF carries an expense ratio of 0.48 percent, while the iShares Japan ETF has an expense ratio of 0.50 percent. Deutsche's Japan hedge ETF has a gross expense ratio of 1.03 percent.
The ratio reflects the total annual fund expenses as a percentage of the value of the investment.
INSTITUTIONS IN ON THE ACT
The new ETFs come at a time when large institutions have also boosted hedging in currencies. Typically, currency hedging has been used less in foreign equities than in fixed-income, and many money managers leave equity portfolios unhedged.
Mellon Capital boosted hedging of its foreign exposure in mid-June to two-thirds of its exposure to non-U.S. dollar assets in its flagship global asset allocation strategy, which invests across multiple asset classes. On average, the firm hedges about 40 percent of its foreign currency exposure, generally using currency forward contracts.
Audrey Kaplan, head of international equities at Federated Investors in New York, said the average currency hedge ratio for her portfolio has risen to about 20 to 30 percent from less than 5 percent before the financial crisis in 2007-2008.
Kaplan manages the $579 million Federated InterContinental Fund, which has a 34 percent exposure to emerging markets. "Overall, EM currencies have depreciated this year and that's been a headwind for the portfolio," she said.
Fear of reduced Fed stimulus has hit emerging economies hard, while active central bank activity is hurting the yen and pound.
Forecasting currency moves and executing hedging can be complicated and it's common for large institutions to hire outside firms to manage currency exposure. For very liquid currencies such as the yen, hedging costs are minimal.
Nonetheless, hedging does not provide immunity against losses. Should foreign currencies rally against the dollar, hedging becomes counter-productive. If equity markets in Japan or elsewhere do poorly as the currency rallies, losses would be magnified.
The strong negative link between stocks and the yen in Japan in recent months has made hedging an especially successful strategy. But the Nikkei's converse relationship with the yen is not a long-standing one, and if it reverses, that would hurt those in hedged funds.
(Additional reporting by Daniel Bases; Editing by Dan Grebler)