This study aims to explore the use of currency-hedged ETFs in portfolio management for risk mitigation. It seeks to understand how these ETFs can help investors hedge against currency risk, leading to improved risk-adjusted returns and enhanced portfolio diversification. Currency-hedged ETFs are financial instruments designed to protect investors from the impact of currency fluctuations when investing internationally. Integrating these ETFs into portfolio management strategies can help investors manage currency risk and optimize their investment outcomes in global markets.
Understanding Currency-Hedged ETFs
What are Currency-Hedged ETFs?
Currency-hedged ETFs are exchange-traded funds designed to minimize the risks of fluctuating exchange rates in ETFs with foreign holdings. They typically hold a basket of foreign stocks or bonds as their underlying investment, along with currency-forward contracts that perform the hedging function. These contracts effectively lock in a predetermined future exchange rate, eliminating the uncertainty of exchange-rate movements.
Mechanism of Currency Hedging
Currency hedging involves using financial instruments, such as foreign exchange forwards, to mitigate the risk of currency fluctuations. These forwards are contracts in which two parties agree to exchange a fixed amount of foreign currency for the base currency at a specified future date. By locking in the exchange rate, currency-hedged ETFs protect investors against potential losses due to currency fluctuations while providing exposure to the underlying assets.
Benefits and Drawbacks of Currency-Hedged ETFs
Benefits of currency-hedged ETFs include limiting currency risk, allowing investors to focus on the underlying businesses and stocks without the impact of currency fluctuations. This can result in more stable returns and potentially bigger dividends. Additionally, currency-hedged ETFs make currency hedging more accessible to smaller retail investors, as they handle the complexities and costs of hedging at a fraction of the cost compared to traditional methods.
Drawbacks of currency-hedged ETFs include the possibility of underperformance compared to an unhedged strategy during periods when currency fluctuations work in favor of the investor. Moreover, hedged ETFs may have higher fees than non-hedged ETFs due to the costs associated with hedging. Lastly, hedging strategies may not always provide a performance advantage, as they can cause funds to underperform for years.
Importance of Risk Management in Portfolio Allocation
Risk management in portfolio allocation is crucial for protecting and growing investors’ wealth. Effective risk management minimizes potential losses, optimizes returns, and improves long-term investment performance. It helps investors make better-informed decisions by analyzing the risks associated with different investments, allowing them to allocate their money strategically and diversify their portfolios.
Diversification is a risk management strategy that involves creating a mix of various investments within a portfolio to minimize unsystematic risk events. A diversified portfolio contains a mix of different asset classes, industries, and geographies, ensuring that the positive performance of some investments neutralizes the negative performance of others. Diversification aims to reduce unsystematic risks, which are specific to individual investments and can be diversified away. By not putting all eggs in one basket, investors can reduce the volatility of their portfolios and manage risk more effectively.
Currency Risk and its Impact on Portfolios
Currency risk, also known as exchange rate risk, arises from changes in the price of one currency relative to another, affecting the value of investments in foreign assets. International investors are exposed to currency risk, which can create unpredictable profits and losses. Fluctuations in currency values can either enhance or reduce the returns associated with foreign investments. Managing currency risk in global portfolios is challenging due to the difficulty in forecasting the impact of risk factors on working capital management. Volatility in foreign exchange markets highlights the need for businesses to carefully consider their currency hedging requirements. Developing accurate forecasts is crucial for tracking and mitigating foreign exchange risks. Additionally, investors need to decide which currency risks to manage and employ appropriate hedging strategies to mitigate or eliminate the risk.
Evaluating Currency-Hedged ETF Performance
Assessing the Effectiveness of Currency-Hedged ETFs in Risk Reduction
Currency-hedged ETFs aim to remove most of the currency risk associated with foreign investments, and they have been effective in achieving this goal. By using currency-forward contracts, these ETFs lock in a predetermined future exchange rate, eliminating the uncertainty of exchange-rate movements.
Measuring Risk-Adjusted Returns of Currency-Hedged ETFs
Risk-adjusted returns measure the profit of an investment relative to the amount of risk taken to achieve it. Common risk measures used in investing include alpha, beta, R-squared, standard deviation, and the Sharpe ratio. By comparing the risk-adjusted returns of currency-hedged ETFs to their unhedged counterparts, investors can evaluate the effectiveness of the hedging strategy in managing risk.
Comparing Hedged and Unhedged ETFs for Risk Management
Hedged ETFs can limit currency risk, allowing investors to focus on the underlying businesses and stocks without the impact of currency fluctuations. However, hedging may cause funds to underperform an unhedged strategy during periods when currency fluctuations work in favor of the investor. Unhedged ETFs can benefit from favorable currency changes but also carry the risk of negative effects of currency price changes. The choice between hedged and unhedged ETFs depends on investor preference, risk tolerance, and investment time horizon.
Portfolio Optimization with Currency-Hedged ETFs
Incorporating Currency-Hedged ETFs in Portfolio Construction Models
Currency-hedged ETFs can be incorporated into portfolio construction models to minimize currency risk in international investments. These ETFs use currency-forward contracts to lock in predetermined future exchange rates, reducing the impact of currency fluctuations on the portfolio
Determining Optimal Asset Allocation with Currency-Hedged ETFs
To determine the optimal asset allocation with currency-hedged ETFs, investors should consider their risk tolerance, investment objectives, and time horizon. By analyzing the potential benefits and costs of hedging, investors can decide whether to include currency-hedged ETFs in their portfolios. It is essential to weigh the potential risk reduction against the higher fees and potential underperformance associated with hedged ETFs.
Backtesting and Stress Testing the Portfolio
Backtesting and stress testing are essential tools for evaluating the effectiveness of currency-hedged ETFs in a portfolio. Backtesting involves comparing the historical performance of the portfolio with and without currency hedging to assess the impact of the hedging strategy. Stress testing evaluates the portfolio’s resilience under various market conditions and scenarios, helping investors understand the potential risks and benefits of including currency-hedged ETFs in their asset allocation.Â
A model Portfolio – Analysis
This investment portfolio is heavily focused on hedged currency equity ETFs, with a significant allocation to the Japanese market. The portfolio aims to mitigate currency risk by investing in currency-hedged ETFs such as HEFA, HEDJ, and DBEU, each holding 5% of the total allocation. The DXJ ETF has the largest allocation at 37.18%, providing exposure to the Japanese equity market while hedging against currency fluctuations. Other ETFs, such as HDEF, LVHI, HFXI, HEZU, DBJP, and DDWM, make up the remaining 22.82%, each contributing 5% to the portfolio. The strategy appears to prioritize international equities while seeking some level of protection against currency fluctuations. Investors should be aware that the performance of the portfolio can be influenced by factors such as currency movements, market conditions, and regional economic performance. Diversification and a balanced approach are important considerations when evaluating the suitability of this portfolio for individual investment goals and risk tolerance.
From the graph below, we observe that the overall best performing portfolio among the three provided is the “Maximum Sharpe Ratio” portfolio. It achieved the highest annualized return of 10.04%, which indicates the highest average return over the investment period compared to the other portfolios. Additionally, the “Maximum Sharpe Ratio” portfolio also exhibited a positive Sharpe Ratio (both ex-ante and ex-post), which suggests a good risk-adjusted return. The Sortino Ratio for this portfolio is also positive, indicating a favorable return relative to the downside risk.Although the “Provided Portfolio” had an annualized return of 8.61%, it still did not perform as well as the “Maximum Sharpe Ratio” portfolio, which achieved a higher return with better risk-adjusted measures. On the other hand, the “Invesco CurrencyShares Euro Currency” portfolio had a negative annualized return of -0.03% and negative risk-adjusted measures (negative Sharpe and Sortino ratios). This portfolio performed poorly and had a high negative correlation with the overall stock market.
In summary, the “Maximum Sharpe Ratio” portfolio is the best performing portfolio among the three provided, with the highest annualized return and better risk-adjusted performance. The provided portfolio has a correlation of 0.86 with the stock market, the Maximum Sharpe Ratio portfolio has a correlation of 0.83, and the Invesco CurrencyShares Euro Currency portfolio has a correlation of 0.34.
Conclusion
Currency-hedged ETFs effectively minimize currency risk in international investments by using currency-forward contracts. These ETFs can provide more stable returns and make currency hedging accessible to smaller retail investors. However, they may underperform unhedged strategies during periods when currency fluctuations favor the investor and have higher fees due to hedging costs. Portfolio managers should consider incorporating currency-hedged ETFs in their portfolio construction models to minimize currency risk. They should determine the optimal asset allocation based on risk tolerance, investment objectives, and time horizon. Monitoring and rebalancing currency-hedged ETFs regularly is essential to maintain the desired risk level and investment objectives. Customizing portfolios based on specific risk appetites can help investors achieve their financial goals while managing currency risk.
Disclaimer: The information provided here is for educational and informational purposes only and should not be considered as financial advice or a recommendation to buy, sell, or hold any securities or investments. Investing in the stock market carries inherent risks, and past performance is not indicative of future results.
