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E TF INVESTMENT STR ATEGY & INSIGHTS The return of currency hedging FEB 2017 The expectation of renewed strength in the U.S. dollar is bringing currencies back into focus. After a year of minor investor interest for U.S. investors, we believe the question of whether to hedge FX1 exposures is going to be an important one in 2017, like it was in 2015. Additionally, currency volatility has been rising over recent years, increasing the need to actively manage Authors currency exposures. Heidi Richardson for U.S. ETFs Maria Eugenia Heyaca Investment Strategist for ETF Investment Strategy & Insights Figure 1: Currency volatility on the rise Implied volatility Head of Investment Strategy 15% 10 5 Summary 2014 Renewed strength in the dollar has brought currency hedging back into focus. We expect the U.S. dollar to post moderate gains over the year. Over the long term, FX hedging should be a case by case consideration with the potential 2015 2016 2017 3 month implied volatility – average of euro, yen and sterling vs. USD Source: Thomson Reuters DataStream and BlackRock Investment Institute. January 13, 2017. Currency hedging tools can be used for both tactical calls (outperformance potential) and long-term strategic allocations (volatility management). In this report, we look at considerations on both fronts: first, trying to address nearterm drivers of major currencies and then looking at guidelines regarding the long-term case for currency hedging. Figure 2: A strengthening greenback Index level for significant risk reduction. 100 95 90 85 80 75 70 2012 2013 2014 2015 2016 2017 U.S. trade-weighted dollar iShares.com Source: Thomson Reuters DataStream and BlackRock Investment Institute. January 13, 2017. Notes: The trade-weighted dollar is a weighted average of the foreign exchange value of the U.S. dollar against a broad group of major U.S. trading partners. 1 FX is a commonly used abbreviation for foreign exchange rate, the rate at which one currency can be exchanged for another. Currency outlooks Although currencies are difficult to time (currency After a post-U.S. election rally, we see the U.S. dollar on volatility is significant when viewed over shorter time a slow appreciation path, driven by a better growth periods), the table below offers some thoughts on what outlook, a pick-up in inflation expectations and we see as the main short-term drivers for a number of anticipation of future Federal Reserve (Fed) interest major currencies. rate hikes. Figure 3: Currency outlook table Currency View/Drivers U.S. dollar The trade-weighted dollar looks set to post a moderate rise on the back of better growth and interest rate differentials. Risks seem to be slightly tilted to the upside if the Fed moves faster than the market expects. Euro We see the euro relatively flat in the near term, with some upside if the European Central Bank were to appear more hawkish. Japanese yen The yen has already fallen notably over the widening U.S. yield advantage. This trend could continue if the yield differential widens further, which is a possibility given the Bank of Japan’s curve management introduced in 2016. Pound sterling We see a more stable path with perhaps some upside potential, as short positions remain high and, once Article 50 is triggered, we could get some more clarity on what “Brexit” will look like. Canadian dollar The Canadian dollar could see some weakness vs. the USD, on relatively slow growth, and widening interest rate differentials. A pick-up in protectionist rhetoric in the U.S. would also be a headwind. Swiss franc The Swiss franc looks mostly range bound for now, especially as the central bank continues to work to prevent a significant CHF appreciation. Australian dollar Potential ratings reviews, China contagion and housing market adjustments are likely to continue to pressure the Australian dollar. Emerging market currencies EM currencies have already adjusted significantly, especially post-U.S. election. If we don’t see a follow-through with protectionist policies we could see some upside—in particular for countries with trade surpluses with the U.S. (LatAm, Russia). Protectionist measures would hurt Asian currencies and the Mexican peso. Mexican peso The path for the Mexican peso will continue to be dependent on U.S. policy developments. We continue to expect weakness as uncertainty subsists, yet a benign trade environment combined with higher U.S. spending could see a relief rally. Still, domestic political uncertainty may put a cap on any significant short-term rally. South Korean won Yield differentials with the USD, an easing bias from the central bank and potential contagion from yuan depreciation point to continued weakness in the South Korean currency. Source: BlackRock, January 2017. To hedge or not to hedge allocation. Historically, this is particularly true in Because every international investment is also an developed markets. In emerging markets, some active currency decision, one should think of currency currencies have shown a trend of continuous hedging not just as a tactical tool, but also as a devaluation, increasing the importance of FX hedging. strategic one. Much has been written about the long term optimal hedging ratio and benefits of hedging (or not) currency exposures. But from a risk perspective, hedging strategies can significantly reduce portfolio risk over long periods of time. This is all the more true when an equity market is significantly positively correlated to its currency:3 Although there is no consensus on an optimal approach, and the decision to hedge is dependent on each investor’s risk appetite, cost of hedging, size of •• When correlations are positive, currency hedging improves Sharpe ratios. This is because the currency foreign asset holdings, etc. we derive a number of exposure heightens the volatility of the position; it is helpful guidelines from our research. The key takeaway: essentially a “return-free risk.” FX hedging is not an all-or-nothing decision, and looking at each currency separately may be the right •• The opposite is true for currencies with negative correlations. In these cases, the unhedged exposure way to go about it. to the equity market provides inherent diversification From a return perspective, it is commonly accepted to the position as equity and currencies move in that major currencies tend to mean-revert 2 over the disperse directions. long term, limiting the return potential of any strategic Figure 4: The impact of currency hedging on Sharpe ratios4 Canada volatility Canada annual returns 6 + 4 2 Positive equity/FX correlation = -0.1% 10 7% 20% 10.0% 8 + 6 4 1.0% Negative equity/FX correlation = 15 Potential diversification 10 16% 17% Unhedged Local Switzerland Sharpe ratio 0.36 0.40 9% 5 Unhedged Local FX Unhedged Local 0 FX 0 Unhedged Switzerland volatility Unhedged 8.9% Local FX 0 12% 2 0.26 5 Switzerland annual returns 10 0.35 14% 15 Return-free risk Unhedged FX -2 Local 0 19% 20% 8.2% 8.0% 8 Local 10% Canada Sharpe ratio Source: BlackRock, Thomson Reuters DataStream, MSCI. Dec 31, 2016. Notes: The Sharpe ratio is calculated using the 20-year average 3-month treasury bill. Annual returns were calculated with a 20-year compound annual growth rate. 2 Mean-reversion is a theory that prices and returns eventually move back toward their average. 3 Currency correlation describes the relationship between a currency and another variable. 4 A Sharpe Ratio is a measurement of risk-adjusted return, defined as the average return of an asset ahead of the risk-free rate per unit of total risk (standard deviation). Figure 5: Composition of DXY Figure 6: Composition of U.S. trade-weighted dollar CNY EUR MXN CAD JPY KRW GBP TWD INR CHF EUR JPY GBP CAD SEK CHF 0% 20 40 0% 60 10 20 30 Percent of composition Percent of composition Source: Federal Reserve, Thomson Reuters DataStream. January 13, 2017. Notes: The currencies in figure 6 represent the top 10 weightings out of 26 U.S. trade partners. Using the right index Investors often use DXY5 as the reference index for The two indices have widely different compositions the U.S. dollar. Yet the composition of the index is (see above) with the most significant discrepancy very tilted towards only a small number of currencies. being the absence of any EM representation in DXY, In comparison, the trade-weighted dollar (a measure when EMs represent over half of U.S. trade flow. favored by the Fed) tracks the moves of the U.S. dollar vs. the 26 largest U.S. trade partners.6 This can lead to different performance with key implications for monetary policy, financial conditions and overall currency considerations. Conclusion The expectation of a somewhat stronger dollar real currency risk embedded in their portfolio. Given brings back into focus the need to hedge currencies the mean-reverting nature of major currencies, the for USD-based investors. But, beyond the short-term return upside may be limited, but the volatility view, any investor with international holdings should advantage can be substantial. Whether tactical or consider the long term effect of currencies on their strategic, this conversation is not going away. portfolios and take a careful look to understand the 5 6 The DXY, the U.S. dollar index, is a measure of value of the U.S. dollar relative to some of the world’s major currencies (Eurozone, Japan, United Kingdom, Canada, Sweden, Switzerland). The trade-weighted dollar is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of 26 U.S. trade partners. iShares offers a comprehensive currency hedged suite with two distinct types of solutions Fully hedged Adaptive hedged If you are looking to capture shorter-term opportunities or simply mitigate currency volatility Global Minimum Volatility HACW Global HACV Global HAWX GlobaI ex U.S. HEFV HHYX Int’l High Yield Bonds Single Country HAUD Australia DEFA HEWC Canada DEZU Europe HEMV Emerging Markets HEWG Germany DEWJ Japan HEUV Europe HEWI Int’l Developed Regional Italy HEWJ Japan HEWW Mexico HEZU The iShares Minimum Volatility ETFs offer Int’l Developed diversified stock market Int’l Developed Small-Cap exposure while seeking to minimize the market’s Emerging Markets peaks and valleys. Europe HEUS Europe Small-Cap HEWL Switzerland HEFA HSCZ HEEM If you would rather not make hedging decisions yourself HJPX JPX-Nikkei 400 HEWY South Korea HEWP Spain Int’l Developed The iShares Adaptive Hedged ETFs dynamically adjust to changing currency markets by employing four currency indicators to determine the level of hedging (0 – 100%). These funds are better suited for longer-term holdings. HEWU United Kingdom Want to know more? iShares.com Share your feedback at: US ETF Investment Strategy & Insights team Visit www.iShares.com or www.BlackRock.com to view a prospectus, which includes investment objectives, risks, fees, expenses and other information that you should read and consider carefully before investing. Investing involves risk, including possible loss of principal. This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries. The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”). ©2017 BlackRock, Inc. All Rights Reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc. All other trademarks are those of their respective owners. Prepared by BlackRock Investments, LLC, member FINRA. Not FDIC Insured • May Lose Value • No Bank Guarantee iS-20014-0117