Hedging the US Dollar in the “Basic Plan”

Recently the US dollar has strengthened against most foreign currencies.  This means that you could buy foreign stocks and they could do well in their local markets (for example, the Japanese stocks were generally up for a time) and yet you would have losses when your ADR or ETF was valued in US dollar terms.

While you cannot generally hedge the currency risk in a single stock ADR (for example, Toyota), they now offer ETF’s that give exposure to foreign markets but also hedge those currencies against the US dollar, so you receive their “actual” return (good or bad) rather than their actual return PLUS the impact of the rising or falling US dollar.

For instance, let’s look at the VEU Vanguard ETF (one of my favorites, the Red line below) against a new ETF I started looking at, HEFA (the Blue line), over the last two years.  You can see that the total return was 1.1% positive in HEFA and 14.2% negative for VEU over that time span.  This difference is due almost totally to the rise in the US dollar against foreign currencies that make up the bulk of those stock indexes (the Euro, the Japanese Yen, the Australian Dollar, and the Canadian Dollar).  You can see that the peaks and valleys of the blue and red lines track together (they move in the same direction) but the red line sinks as the US dollar rises over the last two years.

 

VEU vs HEFA Last 2 years
VEU vs HEFA Last 2 years

One negative impact of this, all else being equal, is that hedging costs money and this should be expected to drive up fees on your ETF.  The ETF for Vanguard (VEU) is 0.14%, which should be considered somewhere near rock bottom.  The HEFA ETF expense ratio is 0.35%, which is also very low, but higher than the Vanguard product.  This isn’t a perfect comparison because generally the Vanguard ETF’s have the lowest expense ratios due to their member-owned structure.  HEFA is part of iShares which is now owned by Blackrock, a major competitor of Vanguard.

It should be noted that the VEU and HEFA indexes aren’t exactly the same in terms of countries that they cover and weighting of markets but as you can see above they generally move closely in tandem and the majority of the difference is due to the impact of the US dollar against foreign currencies.

This is of interest because the US Federal Reserve is considering raising interest rates soon, which theoretically would cause the dollar to rise which would make holding shares in other currencies less profitable.  Of course this is already priced into the dollars’ current level, which could mean in practice that if the Fed doesn’t move fast enough or make enough moves, the dollar would fall.  If anyone ever tells you that they can predict interest rates or currency moves you should not believe them; there is no reliable way to predict either one although there are mass industries of pundits attempting to do so.

Thus for my “basic plan“, the question is, should you also consider adding currency-hedged ETF’s and not just the two basic ETF’s (VEU and VTI).  The question is whether to replace part of your VEU allocation (how much you buy) with something like HEFA (there are other ETF’s, but this seems to be a pretty good one, with a large base of investors and from a company like Blackrock which isn’t going away any time soon).  Here’s what would happen – if the US dollar falls against major foreign currencies, you are going to make less money than you would otherwise if you hedge it.  If the US dollar rises, you will make more money than you would otherwise with the hedged product.  Also note that the hedging may not be perfect, but would likely shield you from the vast majority of the impact, especially on major currencies like the Euro.

I think that this is getting a lot of play in the financial press right now and I predict that at some point these products will be mainstream.   It took a long time to move from “active” to “passive” investing and it has taken many more years for ETF’s to begin to take a large share of new investments away from mutual funds.  This is another long term trend that started on the margin (there were very few currency hedged funds a couple years ago when I looked, and they were expensive) but is now going mainstream, and the additional expenses for hedging seem quite modest (0.14% vs. 0.35%).

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