Email of the day
Comment of the Day

April 14 2014

Commentary by David Fuller

Email of the day

On hedging costs:

“If I missed the following point on hedged ETFs then perhaps others are also unaware.

“In our recent analysis of the iShares MSCI Japan Euro Monthly Hedged ETF (IJPE-L) for our own subscriber base, we noted that from January 2011 to April 2014, the Nikkei Index gained 45% and the yen weakened against the Euro by 30% for a net gain of 11-12% for a Euro-based investor. (the maths isn't straight line).

“Over the same timeline the above ETF gained 24%. At first, I couldn't work out why the ETF had not gained somewhere closer to the 45% gains recorded by the Nikkei considering that it was hedging the Yen currency risk.

“After some head scratching, son, Darren, came to the rescue with the likely explanation. While undoubtedly there are costs associated with monthly hedging, the most likely reason for the shortfall in the ETF's returns versus the Nikkei is that in a rising equity market it is not possible to hedge all the currency risk, if you are only hedging monthly. This next example helps make the point, we think!

“At the start of a month, you hedge your 100 million yen portfolio back to Euros. The market rises, say, 20% and at the end of the month you have 120 million of yen assets, but you (rightly) only have hedging in place for the 100 million Yen. Hence, it isn't possible, on a monthly basis at least, to fully hedge the impact of yen weakness.

“This point can probably be made for all hedged ETFs and something investors might keep in mind. It's not necessarily a negative; rather it is what it is but better to be aware of it than not.”

David Fuller's view

Many thanks to you and your son for sharing your analysis with us.  There are hedging costs, as you point out, and Darren’s assessment also makes sense to me.  Additionally, in a rising market, new money will be flowing into the ETF more often than not, but the additional funds might not be hedged, initially, if the currency positions are adjusted at fixed intervals. 

Any further insights on this topic would be appreciated.

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