The global currency market is one of the crowning achievements of modern finance. On any given day, more than five trillion US dollars worth of currencies changes hands. In terms of size and number of transactions it dwarfs all other asset classes.
Lately, currency markets have been dwarfing other asset classes in another characteristic as well: volatility. This is thanks in large part to the extraordinary measures that central banks around the world have been taking since the financial crisis to stimulate economic growth and mitigate deflationary risk.
For internationally oriented investors, currency volatility can be a nightmare. On January 15 of this year, the Swiss National Bank (SNB) unexpectedly abandoned its Swiss franc/euro peg, and the Swiss currency immediately jumped 30%. A Swiss investor who bought eurozone equities the day before would have seen his or her investment lose almost a third of its value overnight!
Currency hedges to mitigate portfolio risk
While currency risk has always been an issue in international investing, thanks to these unprecedented central bank measures, it can be argued that it is particularly high at the moment.
Events do seem to bear this out. Along with the SNB-induced franc shock, we have seen both the USD and GBP rise on speculation of increased interest rates by the Fed and Bank of England, market turbulence due to a devaluation of the RMB by the Chinese central bank, and just recently volatility in the EUR due to the less-than expected easing measures by the ECB. ¨
As long as we remain in the era of unconventional – and generally uncoordinated – central bank interventions, global investors can expect more of the same. This has helped fuel interest among index investors in currency-hedged ETFs.
A hedged index gives investors the benefits of global diversification while eliminating currency risk altogether. With a currency-hedged ETF global investors need not lose sleep when central bank committees meet to decide policy, safe in the knowledge that their foreign investments are immune to whatever decisions they might make.