How to decide whether it is worth it to hedge currency exposure when investing outside of your home country.
Topics covered include:
- How currency exchange rates impact investment returns
- What factors impact currency exchange rates
- What are carry trades and how do they influence exchange rates
- How currency forward contracts work
- How ETFs and funds hedge currency exposure
- What to consider when deciding whether to hedge foreign currency exposure
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Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is Episode, 364. It’s titled “Should You Hedge Your Foreign Stock Exposure Against Currency Fluctuations?”
An ETF Example
In June 2020 we added a new holding to the Money For the Rest of Us Plus portfolio examples. I also added it to my portfolio; it was the WisdomTree Japan SmallCap Dividend ETF (DFJ). The thesis was that Japan, despite some of its demographic challenges, was growing faster than the U.S. on a per-capita GDP basis and had done so for a decade. Overall earnings, as opposed to earnings per share, had also grown faster in Japan than in the US.
The allocation to these small company dividend-paying Japanese stocks allowed us to benefit from low valuations and above-average earnings growth for a country that had been less impacted, at least at the time, by the COVID-19 pandemic.
The unemployment rate in Japan was low at 2.6%. The overall case level of COVID was low, as was the fatality rate. It seemed like a prudent way to increase stock allocation at attractive valuations. And generally speaking, the ETF has done very well. It’s returned 12% annualized since it was added, but it declined 8% this year, since mid-September. Half of those losses are due to the yen weakening relative to the US dollar. The ETF holds publicly traded companies that trade in Japan and do business in the Japanese yen.
I am invested through a US-based ETF that calculates the net asset value in dollars. Consequently, if the yen weakens relative to the dollar, then that lowers the overall return. If the yen strengthens relative to the dollar, then that will increase the returns. Right now, $1 is worth about 114 yen. It has varied. In 2012, $1 was worth 80 yen. That meant that when you converted $1 to yen, you did not get as many yen, because the dollar was weaker. In 1999, $1 was worth 145 yen. That meant you got more yen per dollar, as the dollar was strong, and the yen was weak.
These currency fluctuations can impact returns, particularly over the shorter term. Year to date, the Japanese stock market has gained 15.5% when denominated in yen. But when we convert those returns into dollars, the Japanese stock market has only returned 5.4%. The weakening yen has led to a 10-percentage point drag in performance this year.
Now, most of the time, we don’t consider exchange rates, unless we’re traveling. I recall traveling in 2008 with my oldest son in the UK, £1 was worth $2. That was the strongest the pound sterling had been in decades. And it felt as we were traveling through the country in London buying groceries, eating out, and we were paying twice as much for everything. By March 2020, £1 was worth $1.16. So it was almost at parity on a currency exchange basis.
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