Your ETF Is Not All It Seems for Emerging-Market Currency Hedges

  • Not everything gets hedged in `hedged' exchange traded funds
  • It's buyer beware when volatility shatters correlations

The devil is in the details for investors looking for safer emerging-market assets after a currency rout that’s stretched from Russia to Brazil.

More than $1.6 billion has flowed into exchange-traded funds that protect against currency fluctuations in developing nations this year, 82 percent more than in all of 2014. Yet buyers of these products, from moms and pops 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’s fine in steady markets, eliminating the cost of pricey forward contracts that can dent returns. But as an emerging-market selloff shakes correlations between currencies, it’s a case of buyer beware.

“You might be OK accepting that, but you should know that going in,” said Dave Mazza, head of ETF and mutual fund research at State Street Global Advisors 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 Inc. and Deutsche Bank AG’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.

‘Jury Out’

The differing strategies may cause issues for less seasoned investors, according to Eric Mustin, vice president of ETF trading solutions at broker WallachBeth Capital LLC.

“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,” Mustin said from New York. “The jury’s still out on which hedged currency ETFs are best.”

BlackRock actively works with its clients to make sure they understand how all of the asset manager’s ETFs work, said 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 said.

FX Rout

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 U.S. burnishes demand for the dollar. All but one of 24 emerging-market currencies tracked by Bloomberg have fallen versus the dollar this year, with Brazil’s real leading declines.

That’s shaking long-standing correlations among developing-nation currencies, and between them and their G-10 peers.

It’s also prompting investors who want, or need, to stay in these nations to hedge, thereby protecting their international returns when repatriated to the U.S. Flows into currency-hedged ETFs -- including those for both emerging and developed markets -- have topped $46 billion this year. That’s up from just $8.9 billion in 2014.

“We optimize a basket,” Orlando Montalvo, a director in BlackRock’s alternative beta strategies portfolio management team, said of the company’s hedged emerging-market fund. “We look at this every single month along with our risk and quantitative analysis team and determine whether we need to add or subtract any pairs to the portfolio.”

Long-term currency correlations are monitored to ensure they provide protection, he said.

Hedging Basket

For example, BlackRock uses the euro as a proxy for the Hungarian forint, Czech koruna and Polish zloty. The fund’s exposure to these three Eastern European currencies -- about 2 percent of holdings, according to data compiled by Bloomberg -- is hedged using one-month forward contracts on the shared currency. About 13 percent of the portfolio is hedged in a similar manner.

“I’m very comfortable with the iShares product because of the depth and liquidity,” said Philip DeAngelo, owner of Highland, New York-based Focused Wealth Management, which oversees about $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.

Cost Considerations

For BlackRock, using the euro to hedge Eastern European risk trims the transaction cost from as much as 70 basis points to as little as one basis point, depending on the size and timing of a trade, according to the company.

Deutsche Bank says it pays about 41 basis points on an asset-weighted basis to hedge currencies across its emerging-market fund, buying forward contracts on each currency exposure within the ETF. A basis point is 0.01 percentage point.

“Our goal is to fully hedge the portfolio using the currency forward markets at the end of the month, irrespective of cost,” said Dodd Kittsley, head of ETF strategy and national accounts in New York at Deutsche Asset and Wealth Management.

The different approaches haven’t stopped either product from losing money this year. BlackRock’s emerging-market currency-hedged ETF has performed slightly better, losing 9 percent in the year through Aug. 28, to Deutsche Bank’s 10 percent.

Despite that, the two funds have taken in about $400 million since Dec. 31, as more than $5 billion flowed out of their unhedged peers. That has industry practitioners suggesting investors wise up about their differences sooner rather than later.

“There’s an extreme demand for it because of course those currencies tend to be a bit more volatile,” Brad Zucker, a senior product manager at FTSE Russell, which provides indexes for ETFs, said from New York. But investors “want to know ‘when I’m buying something, am I getting the exposure that I want?”’

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