The Value and Importance of Currency Hedging in 2022

In an environment of global inflation and rising interest rates, advisers and investors should be aware of how changes in exchange rates can affect their international investments. A recent webcast featuring DWS and 3EDGE and hosted by Tom Lydon, CEO of ETF Trends, discusses the short and long-term outlook for currencies, the 2022 world currency outlook, and FX strategies that include currency hedging.

Dr. Liang Ding, Co-Head of Currency Strategy, Macroeconomic Research, DWS, discusses the positioning and valuation shifts that have been seen over the course of 2021, with the US Dollar starting the year undervalued against the other currencies and the overvalued ending.

“The US dollar became the strongest currency last year, and in fact the dollar had the best performance since 2016,” says Dr. Liang Ding. “In retrospect, the trends in the dollar seem easy to explain: the Fed’s hawkish, high-yielding support for the US dollar.”

Other contributing factors were valuation and market positioning, US growth and asset attractiveness, but Dr. Ding does not believe all of these factors will impact performance in 2022. DWS expects that the United States will have a below-average growth differential this year compared to the rest of the world.

Despite the stabilization of the manufacturing PMI over the past few months, the gap between performance and the PMI has remained wide in the United States “What this tells us is that the positive news, we have seen some stabilization in the sentiment, but this quality of sentiment in the currency market is not yet reflected,” says Dr. Liang Ding.

Currency hedging strategies

Jason Chen, Principal Research Analyst at DWS, discusses hedging strategy frameworks for the MSCI EAFE Index (which contains countries from Europe, Australasia and the Far East) and how they can reduce volatility in 1.5-2% and provide modest carry. Chen explains that the differential and volatility seen in the forex markets is due to both the volatility of the currency as well as the correlation with their underlying equity markets. Hedging international investments is a necessary tactic to reduce risk.

“The reason why that’s so important is that when you’re buying, say, EAFE stock, for example, and you’re not hedging it, what you’re doing is you’re effectively buying a basket of those currencies, then you’re also buying the local stock market,” Chen explains. “In a way, you have 100% exposure to currencies, and then you have an additional 100% exposure to stocks.”

DWS offers a suite of currency-hedged international equity ETFs based on desired market exposure, including XTrackers MSCI All World ex US-Hedged Equity ETF (DBAW) and the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF)as well as several others.

Fritz Folts, Managing Partner and CIS for 3EDGE Asset Management, then discusses hedging strategies and explains that most foreign investments do not hedge currency exposure.

“If you’re an advisor and you decide to make equity investments outside the US, you’re probably better off going with a hedged product,” says Folts. “You take other different exposures that are hard to achieve in terms of currency.”

3EDGE approaches investing by analyzing the long term through valuation factors such as growth and cost of capital, the medium term through economic factors such as interest rates and yield curves, and the short term through behavioral factors such as investor psychology.

An example that Folts gives of the importance of hedging is the performance of Japanese stocks in 2021, which performed strongly in yen, the local currency, but after converting back to USD, most of those returns were lost in a product not hedged due to yen weakness.

“If you’re on the fence, we as practitioners actively seeking exposure to ex-US currencies would accept currency risk, but if I’m an advisor and think the US market is significantly overvalued, think that there might be better value outside of the US, now I feel like I would probably want to do it hedged,” says Folts.

Financial advisors interested in learning more about currency hedging can watch the webcast here on demand.

Learn more at ETFtrends.com.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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