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An ETF to Hedge Currency Risk in International Markets

This article was originally published on ETFTrends.com.

While the United States is on path to revamp the North American Free Trade Agreement with Mexico and is moving forward with talks to settle trade disputes with China, it reminds investors exposed to international markets that hedging currency risk is a must.

Rather than obtaining direct exposure to foreign currencies themselves, exchange-traded funds like the IQ 50 Percent Hedged FTSE International ETF (HFXI) are able to provide hedging strategies for investors seeking global opportunities that allow them to capture any upside in foreign currencies and minimize downside risks associated with market downturns related to that respective currency. With the fluctuations in foreign exchange currency against the dollar the past year, a hedged strategy has been able to outperform an unhedged strategy.

"Going back just one year, we have seen hedged currency outperform for several months, then unhedged outperform for 3 months, then hedged outperform again for over 6 months," said Salvatore Bruno, Chief Investment Officer of IndexIQ.

HFXI seeks investment results that correspond to the FTSE Developed ex North America 50% Hedged to USD Index. The index itself represents an equity benchmark comprised of international stocks from developed markets with approximately half of the currency exposure of the securities included in the underlying index hedged against the U.S. dollar on a month-to-month basis.

The trade wars, particularly between the United States and China have negatively impacted the market, giving the major indexes a roller-coaster ride despite the upward trajectory seen in the bull market. The S&P 500 is now the longest bull market recorded, but the road to its record high was marred by trade wars.

However, according to Bruno, incorporating HFXI into a portfolio as a middle-ground alternative can help lessen the impact of future geopolitical ramifications stemming from trade wars or other issues abroad..

"The trade wars have definitely introduced uncertainty and volatility around how currencies move, so the impact would make the case for a middle-ground approach like HFXI," said Bruno. "It is difficult to say if HFXI has been negatively affected because it depends on the frame of reference: HFXI has underperformed fully hedged as the dollar has rallied during the trade war. However, HFXI has done better than the unhedged international exposure as local currencies have weakened. Whether it be a hedged or unhedged approach, the 50% passive approach takes away the timing concern from either being committed to exposure or sacrificing exposure to currencies."

Furthermore, the rising tide of the U.S. dollar against foreign currencies has presented challenges for investors allocating capital towards global opportunities. The U.S. Dollar Index has risen 3% year-to-date and almost 2% within the past year, which would pose an issue for unhedged international currency investments.

Source: tradingeconomics.com

However, investors can strategically use HFXI in conjunction with currency derivatives to derive profitable opportunities. At the same time, HFXI can be used by investors as a more tax efficient means to investing in foreign currencies versus trading the actual currencies themselves.

"HFXI is appropriate for those who understand that timing U.S. dollar and foreign currency strength is better traded using a specific timing strategy with currency derivatives," said Bruno. "To switch from hedged to unhedged international equity ETF’s, or vice versa, is very inefficient. For one, the investor incurs a taxable event if the timing is correct, and those taxes are realized by selling and buying the same underlying equities; this is not an efficient way to trade currencies.

"If the currency call is incorrect, the currency trade losses may erode any equity returns the investor was likely originally intending on experiencing. Our experience is to either trade the currencies more efficiently using derivatives or take the strategic approach of 50% currency exposure, particularly because it is more common to see currencies come back to parity over time. The investor experiences less return dispersion compared to the hedged versus unhedged options by taking the middle-ground."

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