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International ETF Investors Should Hedge Currency Risks

This article was originally published on ETFTrends.com.

With the U.S. dollar strengthening against its foreign counterparts, international stock investors should consider currency hedged exchange traded fund strategies to limit further foreign exchange risks.

"Actively predicting currency moves is nearly impossible. Hedging some or all of an international portfolio is simple. Our call is for a stronger U.S. dollar with a supportive interest rate regime, this is likely to leave most international portfolios exposed. Not hedging is simply taking a position against the U.S. Dollar," Luke Oliver, Head of U.S. ETF Capital Markets, said in a research note.

DWS has maintained a belief that the U.S. dollar could strengthen since March. The asset manager based their call on three 25 basis point rate hikes through March 2019 as the U.S. Federal Reserve tightens its monetary policy and weaker data out of foreign markets suggest possible easing or at the very least not tightening.

Foreign central banks that are holding huge amounts of USD-denominated debt and economies relying on exports to the U.S. do not want to see a weak dollar either.

Meanwhile, the widening interest rate differential due to Fed rate hikes may cause some unwinding of dollar shorts and diminish hedging from overseas investors, notably those heavily invested in U.S. debt, which may further support the bullish USD outlook.

A "Perfect Storm" for Currency Hedging

"We feel the widening interest rate differential creates a 'perfect storm' for currency hedging. The currency hedges themselves have an implicit implied cost or benefit regardless of moves in the currency, which is commonly referred to as 'carry,'" Oliver said.

Specifically, Oliver calculated that a MSCI EAFE basket could help currency hedgers earn a positive carry of 2.38% since U.S. rates are higher than foreign rates.

"This means that in developed markets you currently earn 2.38% carry to hedge, get reduced volatility and get potential mitigation from our forecast that the U.S. dollar will continue to rise," Oliver added.

A rebounding dollar or weakening overseas currencies are likely to help currency hedged exchange traded funds, such as the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) . As the U.S. dollar strengthens, foreign currencies would depreciate. If an investor holds a foreign stock that is denominated in the local currencies, a weaker foreign currency would translate to a lower USD-denominated return on that foreign equity exposure. DBEF provides exposure to equity securities in developed international stock markets, while at the same time mitigating exposure to fluctuations between the value of the U.S. dollar and non-U.S. currencies.

Additionally, something like the Xtrackers MSCI Emerging Markets Hedged Equity ETF (NYSEArca: DBEM) can provided a currency hedged way to access the emerging markets in case the U.S. dollar continues to strengthen.

For more information on the currency hedging strategy, visit our currency-hedged ETFs category.