Buyer beware, when buying hedged currency ETFs

While Deutsche Bank (left) hedges out the currency risk of each equity in its portfolio, BlackRock mitigates risk with forward contracts on 10 of the 22 overseas currencies its iShares ETF has exposure to.
While Deutsche Bank (left) hedges out the currency risk of each equity in its portfolio, BlackRock mitigates risk with forward contracts on 10 of the 22 overseas currencies its iShares ETF has exposure to.PHOTO: BLOOMBERG

Investors may not be as well protected as they think amid sell-off in emerging markets

NEW YORK • The devil is in the details for investors seeking safer emerging market assets after a currency rout that has stretched from Russia to Brazil.

More than US$1.6 billion (S$2.3 billion) has flowed into exchange traded funds (ETFs) that protect against currency fluctuations in developing nations this year, 82 per cent more than in all of last year.

Yet buyers of these products - from retail to institutional investors - may not be as protected as they think.

While some ETFs hedge out each and every currency exposure, others rely on a basket of exchange rates to mitigate risk.

That is fine in steady markets, eliminating the cost of pricey forward contracts that can dent returns. But as an emerging market sell-off shakes correlations between currencies, it is a case of buyer beware.

"You might be OK accepting that, but you should know that going in," said Mr Dave Mazza, head of ETF and mutual fund research at State Street Global Advisers in Boston. "When you start to see the growth in the number of products, it comes down to, how do you do your due diligence, because you still need to know what you own."

BlackRock and Deutsche Bank's wealth management unit run the two most popular hedged ETFs that focus on emerging market stocks. While Deutsche Bank hedges out the currency risk of each equity in its portfolio, BlackRock - the world's biggest money manager - mitigates risk with forward contracts on 10 of the 22 overseas currencies its iShares ETF has exposure to.

The differing strategies may cause issues for less seasoned investors, according to Mr Eric Mustin, vice-president of ETF trading solutions at broker WallachBeth Capital. "The more retail-focused guys aren't thinking about the differences; they're looking at what is free to trade through their brokerage system or what they've seen an advertisement for," said Mr Mustin. "The jury's still out on which hedged currency ETFs are best."

BlackRock works with its clients to make sure they understand how all of the asset manager's ETFs work, said Mr Paul Young, a spokesman at the New York-based firm. Its hedging methodology provides the most cost-efficient outcome for clients while still providing robust protection from currency volatility, he added.

An index of emerging market currencies has tumbled to its lowest level since at least 1993 as a slowdown in China erodes the appeal of developing economies, while the prospect of higher interest rates in the US burnishes demand for the greenback.

All but one of 24 emerging market currencies tracked by Bloomberg have fallen versus the US dollar this year, with Brazil's real leading the declines.

"I'm very comfortable with the iShares product because of the depth and liquidity," said Mr Philip DeAngelo, owner of Highland, New York-based Focused Wealth Management, which oversees about US$470 million and holds the hedged emerging market fund.

"Their hedging costs are extremely low compared to everybody else's."

Hedging is often expensive in emerging markets, where the difference between the price at which counterparties buy or sell a particular currency is wider than for developed peers, reflecting lower liquidity and trading volumes.

BLOOMBERG

A version of this article appeared in the print edition of The Sunday Times on September 06, 2015, with the headline 'Buyer beware, when buying hedged currency ETFs'. Print Edition | Subscribe