U.S. investors have fully embraced the idea of diversifying their portfolios with international equities. However, investing outside the border of the U.S. exposes portfolios to currency fluctuations.
As the U.S. and other developed markets continue a policy of loose money and deficit spending, the future of global currencies and the relative strength of the U.S. dollar remain a question mark.
In this case study, we take a look at the question of whether an investor should hedge currency risk and how they can use ETFs to do so.
Whether or not to hedge currency risk has proponents for both sides. One camp argues that, if your income, expenses and wealth are all denominated in one currency, then why worry about the strength of the dollar. On the other hand, if you are planning to buy a retirement home outside of the U.S. or are investing to gain exposure to a fast growing market, you may want to take the ups and downs of the dollar out of the equation.
One way to hedge currency risk is to simply invest in the very large multi-national companies that generate an extensive portion of sales and earnings from outside the U.S. Those companies have professional staffs that manages exposure to currency fluctuations so you don’t have to.
Another option is one of the new exchange traded funds that has currency hedging built in.
Finally, for the do-it-yourselfers, many currency ETFs are available for establishing a currency hedge that is customized for your portfolio.
For exposure to large multi-nationals, look for large-cap and mega-cap ETFs in the Market Cap directory. The Vanguard Mega-Cap 300 ETF (MGC) tracks the largest 300 companies in the U.S. Top holdings include Exxon Mobil, Microsoft, Procter & Gamble, Johnson & Johnson, and Apple which all have extensive operations outside of the U.S. For example, less than 20% of Exxon Mobil’s sales and profits come from North America.
WisdomTree recently launched a couple of ETFs that come with currency hedging built in. The WisdomTree International Hedged Equity Fund (HEDJ) tracks an index that provides exposure to equity securities in Europe, Far East Asia and Australasia, while at the same time hedging exposure to fluctuations between the value of the U.S. dollar and selected non-U.S. currencies in these regions.
Another ETF, the WisdomTree Japan Hedged Equity Fund (DXJ), was recently modified to include hedging Japanese yen exposure.
ETF investors can gain long and short exposure to the U.S. dollar as well as many foreign currencies. The PowerShares DB US Dollar Bullish Fund (UUP) provides long exposure by taking positions in long futures contracts. A similar fund that provides short exposure is the DB US Dollar Bearish Fund (UDN).