How to invest in currency ETFs

Ask most advisors about stocks, bonds and commodities, and they’ll likely give you a detailed answer. But when it comes to investing in currencies, there’s a knowledge gap in the industry, says Tyler Mordy, president and CIO of Forstrong Global Asset Management Inc. in Kelowna, B.C.

With currencies having a greater impact on portfolio returns as a result of more interconnected global economy and markets, however, it’s time to pay attention. “A large opportunity exists for active currency management since there are not a lot of players,” he says.

Currencies, explains Mordy, are “very much like stocks and bonds in that they can become wildly overvalued and overloved, and undervalued and underloved.”

The typical way to have exposure to currencies is through hedged or unhedged securities, including ETFs. For instance, Mordy notes an investor might like Japanese stocks, but not the yen. “You can buy an ETF that goes long Japanese equities but shorts your yen exposure”—in other words, a Canadian-dollar hedged Japanese equities ETF.

Pros and cons of currency-hedged ETFs

Pros

• If the Canadian dollar appreciates against the other currency, you protect your portfolio from the negative impact of potential currency losses.
• You don’t need to manage currency exposure.

Cons

• Running a currency hedge overlay costs money, and this cost typically gets reflected in tracking error.
• Currency hedges are not perfect. You could still have intra-month or intra-day currency risk.
• You will not benefit if the other currency appreciates against the Canadian dollar.

Source: Mark Noble, head of sales strategy at Horizons ETFs Management (Canada) Inc.

Mark Noble, head of sales strategy at Horizons ETFs Management (Canada) Inc. in Toronto, adds that most international and U.S. equity ETFs in Canada have both hedged and unhedged versions.

For Canadian investors, the challenge with hedged versus unhedged is when you have U.S.-dollar exposure. Canadian investors who invest in U.S. equities “must choose between hedged and unhedged ETFs. Each have their advantages,” Noble says. “For instance, for currency-hedged ETFs, you don’t need to worry about managing currency exposure as it’s a non-factor. Meanwhile, for non-currency hedged, there’s less tracking error because there’s no additional cost to hedge the portfolio.”

Read: What to consider as currency volatility increases

For instance, if your client bought an unhedged ETF that invested in the S&P500 in Canadian dollars in 2015, she might have earned about 19% when the U.S. dollar appreciated, says Noble. If she had owned the hedged version, however, she would only have gained 2%. “Last year, we saw a trend reversal where the U.S. dollar started to come down relative to the Canadian dollar,” making a hedged ETF a better choice at that time.

The key is to stick to either hedged or unhedged for the long term. That’s because historically, the U.S. dollar and Canadian dollar are a wash. “Over 10 to 12 years, you come up with periods of dislocation, but it’s not a huge difference over time,” notes Noble.

Another option is to invest in currencies through currency ETFs, which give an investor direct exposure to a particular currency, says Mordy. Essentially, the ETF tracks the performance of a single currency against another currency or a basket of currencies.

Mordy suggests that, regardless of which ETF option suits your client’s risk profile and goals, “every investor should have a portfolio with several currencies and be globally diversified in their currency exposure. ETFs offer the most tax-efficient and lowest-cost exposure to currency trends.”

Risks and rewards

Currency ETFs can help manage risk during difficult markets because they have a low correlation to other asset classes.

Mordy notes that before the 2008 crash, his firm was looking for asset classes that “have shock-absorbing properties during a bear market. We found that in Asian currency ETFs. They tended to behave a lot better during that market period, so we were overweight those through 2008.”

Read: 5 reasons advisors are turning to ETFs

Certain emerging Asian currency ETFs continue to be a better safe haven than the Japanese yen, Swiss franc or gold, he adds. “When the North Korean crisis was raging in August 2017, traditional safe havens didn’t work. But the Chinese renminbi was stable and rose during that crisis.”

Still, these instruments aren’t without some risks. Currencies can be volatile, warns Noble. “Having some exposure is beneficial, but you’re not going to put 30% of your portfolio in currencies. Big moves in currencies would likely be too much for the risk tolerance of most investors.”

Mordy adds that some currency ETFs can be more cyclical than others. “During commodity meltdowns, cyclical currencies like the Brazilian real can lose a third of their value quite quickly.”

Instead, he suggests finding ETFs that don’t attract a lot of media attention, which could allow them to become undervalued. One example would be ETFs denominated in the Polish zloty.

Outlook for currency ETFs

The consensus is the U.S. dollar is set to decline as a result of global growth elsewhere, Noble says.

“We’re seeing positive growth in almost every region in the world right now,” he says. “This means they’re starting to raise interest rates and end quantitative easing. You’re probably going to see a gradual decline in the value of the U.S. dollar because the rest of the world is coming online.” However, he adds, “All of this can be easily derailed by uncertainty over a growing economic climate of trade tariffs and protectionism.”

Read: What’s boosting the U.S. dollar—for now

Mordy recommends minimizing exposure to U.S. dollars and overweighting emerging markets currencies. “These markets have had a slowdown over the last four years and local currencies have suffered,” he says. “They’ve only started to accelerate in the last year. Once you get a currency trend going in emerging markets—despite recent volatility–it tends to last for a few years.”

Overall, experts agree that the key is to decide whether you want hedged, unhedged or direct exposure to a currency. Then find an ETF that invests in an undervalued currency and stick with it for the long term.