The recent rise in volatility in the euro currency reminds us that when invested in ETFs, we can be exposed to currency risk. In this article, we will explain that risk and identify the different ways to manage it.

SEE: Hedge Against Exchange Rate Risk With Currency ETFs

What Is ETF Currency Risk?
Let's recall the basic idea behind the ETF industry. ETFs give investors access to markets and companies that are otherwise hard to reach. By purchasing an ETF share, the investor owns a piece of a fund that buys shares in companies in which the investor is interested.

An ETF that invests overseas will generally own shares in the foreign territory and, in general, these will be held in the foreign currency. Therefore, by buying such ETFs, you are exposed to movements in the foreign exchange rate between the currency that your ETF is listed in and the currencies in which the ETF's assets are held.

How might this risk affect your investment? Imagine that the price of the overseas shares does not change over the next six months. You might expect that your ETF's value will also be unchanged. However, because of the currency risk, this is not necessarily true. If the exchange rate changes between the currency your ETF is listed in and the foreign currency changes, then your ETF can change in value, even though the value of the underlying assets has not changed.

As the ETF holder, you are generally long the overseas currency via your ETF. If the overseas currency strengthens, the holdings of your ETF are worth more in the ETF's listed currency, and therefore, the ETF will be more valuable.

SEE: Managing Currency Exposure In Your Portfolio

Dealing with ETF Currency Risk
So what are your options in dealing with ETF currency risk?

Do Nothing
You might decide you are prepared to take the rough with the smooth. If you own many ETFs invested in various countries then you might argue that your portfolio is diversified and that it may all balance out. A health warning here is that if your ETFs are listed in U.S. dollars, remember that the U.S. dollar is generally viewed as the world's reserve currency of choice. This means that, at times in the past, the U.S. dollar has strengthened or weakened in value against many other currencies simultaneously, thus diversification may not always be as effective as hoped.

Another viewpoint is that you are presumably investing in the overseas companies via the ETF because you expect those companies to succeed. It could be argued that economically successful countries will tend to have stronger currencies. In other words, you may think that the ETF currency risk discussed above will generally work in your favor, given your expectation about those companies and countries. This is very much a value judgment, but it is an approach taken by many investors.

SEE: The 6 Most-Traded Currencies And Why They're So Popular

Hedge Your Currency Risk
If you want to mitigate the currency risk either partially or fully, you can hedge your position. There are several ways to do this. One way is to find an ETF provider that offers this as part of the fund's specification. Another is to hedge yourself using FX futures contracts or even FX ETPs. You will probably need to use 'Short' FX ETPsn because they are generally listed in terms of the domestic currency (which you need to sell).

Remember, for ETFs that are invested in companies in multiple currencies, you will need to hedge each currency separately in the correct ratio. This might be onerous or costly. You could instead just hedge partially or just hedge the larger currency exposures in the fund.

Hedge the Right Way!
This cannot be stressed enough and FX trading is notorious for this simple pitfall. If you hedge the wrong way, you do not eliminate your risk, you double it! One great tip to make sure you are hedging the right way is to backtest. Check the price of your ETF and the underlying shares from a year ago (for example) and check the relevant FX rates at that time. Now see how they have changed since. If the ETF's price has fallen by 20% but the underlying shares or index have only fallen by 10%, would your FX hedge be able to make up for the other 10%?

The Bottom Line
ETFs that invest overseas can offer the investor a relatively low-cost vehicle to broaden their investment horizons. However, there can be a currency risk that should be understood. There are several options in order to deal with this risk (including doing nothing and viewing this risk as part of the opportunity). The first step is always to understand the risks, before deciding the strategy to fulfill your investment goals.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares Asia 50

    Read more about BlackRock's iShares Asia 50 Fund, an ETF that follows the four "Asian Tiger'' nations plus China.
  2. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  3. Mutual Funds & ETFs

    ETF Analysis: WisdomTree International LargeCp Div

    Learn more about the WisdomTree International LargeCap Dividend fund, an income-based international equities ETF that focuses heavily on the United Kingdom.
  4. Investing

    Automating Your 401(k) is Easier Than You Think

    If you like automation, you should check out these features that many 401(k) plans offer.
  5. Trading Strategies

    Only Take a Trade If It Passes This 5-Step Test

    Not every moment is a good trading opportunity. Put each trade through this five-step test, so you're trading only at the best profit potential times.
  6. Mutual Funds & ETFs

    ETF Analysis: United States Gasoline Fund

    Learn about the United States Gasoline Fund, the characteristics of the exchange-traded fund, and the suitability and recommendations of it.
  7. Mutual Funds & ETFs

    ETF Analysis: United States 12 Month Oil

    Find out more information about the United States 12 Month Oil ETF, and explore detailed analysis of the characteristics, suitability and recommendations of it.
  8. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Nasdaq Biotechnology

    Find out information about the ProShares Ultra Nasdaq Biotechnology exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  9. Mutual Funds & ETFs

    ETF Analysis: Direxion Daily S&P Biotech Bull 3X

    Learn more about the Direxion Daily S&P Biotech Bull 3x exchange-traded fund, a new triple-leveraged ETF tracking biotechnology equities.
  10. Mutual Funds & ETFs

    ETF Analysis: First Trust Health Care AlphaDEX

    Learn more about the First Trust Health Care AlphaDEX exchange-traded fund, an indexed fund that uses an advanced stock selection methodology.
RELATED TERMS
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  3. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  4. Net Line

    The amount of risk that an insurance company retains after subtracting ...
  5. Political Risk Insurance

    Coverage that provides financial protection to investors, financial ...
  6. Systematic Manager

    A manager who adjusts a portfolio’s long and short-term positions ...
RELATED FAQS
  1. Can mutual funds invest in commodities?

    Mutual funds can invest in commodities. In fact, mutual funds may provide a better way for investors to gain exposure to ... Read Full Answer >>
  2. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  3. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  4. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!