Your ETF is not all it seems for emerging-market currency hedges

New York: 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 (Dh5.9 billion) has flowed into exchange-traded funds that protect against currency fluctuations in developing nations this year, 82 per cent 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 sell-off 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.

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 US 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 US. 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 optimise 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 per cent of holdings, according to data compiled by Bloomberg — is hedged using one-month forward contracts on the shared currency. About 13 per cent 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.