Hedged ETFs – Managing currency risks of global ETFs
Investors in global ETFs may notice that their performances don’t seem to mimic what you hear in the financial news at night.
For example, on 26 Feb 2016, the S&P 500 closed with a loss of 0.2% in the US. Yet the next trading day in Australia (29th Feb), IVV (tracking the S&P 500) opened up 1.1%.
A key cause of this difference is the foreign exchange rate between AUD vs USD. Over that weekend, the AUD dropped by 1.5% against the USD.
Investing in global ETFs exposes your portfolio to a new element of risk - currency risk.
So clever ETF operators are addressing this by creating replica ETFs that are currency hedged. i.e. IHOO is the hedged version of IOO and IHVV is the hedged version of IVV.
What currency risks?
Global ETFs track an overseas index. These indices are generally measured in their home currency or USD. For example, the S&P 500 index is dominated in USD.
The stocks within the ETF (the US shares) trade in USD. Since these ETFs are traded on the ASX, they are quoted in AUD. You effectively convert the USD valued assets into AUD. This means the performance of an ASX listed global ETF is unlikely to move in exact momentum to the underlying global index.
For example, if the S&P 500 moves up by 3% and AUD / USD exchange rate does not change, then IVV should move up by 3%.
If S&P 500 doesn’t change in value, but the AUD weakens against the USD by 2%, then IVV share price should increase by 2%.
Even if the price of the index doesn’t change, the ETF share price is at risk to changes in the foreign exchange rates - current risk.
The smart ETF operators have introduced hedged ETFs to remove the currency risks of investing in global ETFs.
These ETFs take out Forward Contracts to lock in an AUD / USD rate one month in advance. Then they keep rolling that contract every month (some ETFs may roll daily)
This means on 1 Feb, if the AUD / USD rate is 0.72, the ETF will buy a forward contract to lock in 0.72 exchange rate for 1 March. Then they continue this process.
Forward contracts help these ETFs remove currency risk. Leaving you with pure exposure to the performance of the underlying index, less the fees.
Hedging when AUD drops in value
A consequence of hedging is that sometimes you lose out on returns.
If AUD weakens against the USD, the forward contract is out of money. You will end up paying a higher price for the AUD / USD conversion than if you went to market at that time.
This is exactly what happened to hedged ETFs over 2015. The chart below shows that the unhedged IVV beat its hedged version IHVV by 3.07% even though they both track S&P 500. The key reason here is that AUD weakened against the USD from 0.81 to 0.72 over the year.
Obviously, the reverse is true when AUD appreciates in value, when the hedge would provide a positive payoff.
Examples of Hedged ETFs
Hedged ETFs is a growing bunch, at the time of writing there are the following:
- IHVV which is a hedged IVV tracking the S&P 500
- IHOO which is a hedged IOO tracking the S&P Global 100
- WXHG which is a hedged WXOZ tracking the S&P Developed Markets Large & Midcap
- VGAD which is a hedged VGS tracking the MSCI World ex-Australia
Overall, hedged ETFs do a great job for their intended purpose - providing pure play exposure to the underlying index without currency risks. Even though hedged ETFs underperformed unhedged ETFs in 2015 (due to the weakening AUD), they are a good option if you just have a view about a market and don't want to think about potential currency implications.