Know Your Risk
Removing the currency risk embedded in an equity portfolio can take a source of return out of the investment equation. Making the right call on the rise of non-domestic assets is not always enough — currency losses can potentially erode profits. While a currency’s impact tends to mean revert over a long enough time horizon (academic theory states 15–20 years), investors with shorter time horizons are more exposed.
Drivers of Currency Valuations
Various factors can influence currency valuations, including inflation, interest rates, and a country’s rate of productivity and terms of trade. Divergent or unconventional monetary policy can also have an impact.
Although the US has aggressively cut rates to combat the effects of the COVID crisis on the economy, signs are beginning to emerge that the US Federal Reserve (Fed) may be required to hike rates sooner than predicted due to increasing inflationary pressures. Although the Fed continues to insist that signs of inflation remain transitory, the tone has become somewhat more hawkish in the last few weeks. The ECB, on the other hand, has not given any indication that it plans to raise rates in the near future.
Outsized currency moves have been common and there are examples from the recent past. A January 2015 decision by the Swiss National Bank removed the longstanding peg between the Swiss franc and the euro, causing the Swiss currency to rise 20% against the euro overnight. Similarly, the People’s Bank of China decided, in the summer of 2015, to allow the yuan to depreciate by more than 4% against the US dollar, sparking the largest move by the yuan in 20 years. Looking back through history, there are numerous episodes of investors being caught wrong-footed because of currency movements.
Why a Euro Investor Might Consider Hedging an S&P 500 Exposure
As Figure 1 illustrates, when interest rates diverged during the Fed's tapering cycle in 2013, causing a relative weakness in the EUR/USD, a euro investor would have been better off being long the S&P 500 on an unhedged basis. During the COVID crisis in 2020, the USD again saw a significant rally, when demand for US dollar increased due to its status as the global reserve currency.
However, as the euro area begins to ramp up its vaccine program, the economic recovery appears likely to gather steam in the region. Moreover, many investors have begun to question whether the USD can maintain the dominance it has enjoyed over the past few decades, and thus there is a risk the euro may begin to appreciate against the US dollar.
Figure 1: Cost of Hedging S&P 500 Returns into EUR vs. Spread Between 1m USD Libor and 1m Euribor
How to Hedge an S&P 500 Portfolio
SPDR offers a euro currency-hedged share class of its S&P 500 UCITS ETF. This share class tracks the S&P 500 EUR Dynamic Hedged Index.1
The index methodology employs rolling one-month FX forward contracts, which aim to hedge the currency exposure of the underlying securities into the relevant base currency of the hedged index.
Unlike existing currency-hedged indices, the dynamic hedged index — as well as rebalancing the hedges monthly — also has an intra-month reset, in the case that the hedge ratio goes below 95%, or above 105%. This reset ensures that the index does not become over- or under-hedged beyond these thresholds, which also complies with UCITS regulations.2
A dynamic hedged methodology balances the cost efficiency of monthly hedging versus the tighter tracking of more frequent hedging.
Historically, this has led to the dynamic hedged index relatively outperforming the standard hedged index over 1 and 10-year periods (see Figure 2).
Figure 2: Index Performance — S&P 500 EUR Dynamic Hedged vs. S&P 500 EUR Hedged (Annualised Net Total Returns)
SPDR S&P 500 EUR Hdg UCITS ETF (Acc) provides investors with a cost-efficient* and transparent way of gaining US large cap equity exposure on a hedged basis (unhedged exposure is available via the SPDR S&P 500 UCITS ETF (Dist)).
• First hedging methodology fully compliant with UCITS rules around maintaining hedging ratios.
• Dynamic, transparent methodology based on recently developed hedging benchmarks created through collaboration between S&P Dow Jones Indices and State Street Global Advisors portfolio managers.
To learn more about these ETFs, and to view full performance histories, please click the links below to visit the fund pages.
Reset Frequency: Monthly, on the last day of each month. The index also includes a mechanism that aims to ensure that the index does not become over-hedged beyond 105%, or under-hedged below 95%, of the parent index currency exposure. If either threshold is breached, an intra-month adjustment to the index is triggered to reset the hedge ratio to 100% after the close of the following business day.
Index Implementation: Exposures to be hedged are determined each month-end. FX forward contracts are notionally entered into to sell all currency exposures of the parent index in exchange for the base currency of the currency-hedged index.
FX Forward Rates: 1-month FX forwards at 4pm WM/Reuters.
* Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
1 Inception date of the hedged index was 30 July 2018.
2 Source: https://esma.europa.eu/sites/default/files/library/opinion_on_ucits_share_classes.pdf.
3 Source: S&P Dow Jones Indices, as of 31 May 2021.
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Information Classification: General Access. Global Entities.
For Investors in Austria: The offering of SPDR ETFs by the Company has been notified to the Financial Markets Authority (FMA) in accordance with section 139 of the Austrian Investment Funds Act. Prospective investors may obtain the current sales Prospectus, the articles of incorporation, the KIID as well as the latest annual and semi-annual report free of charge from State Street Global Advisors GmbH, Brienner Strasse 59, D-80333 Munich. T: +49 (0)89-55878-400. F+49 (0)89-55878-440.
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Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
Hedging involves taking offsetting positions intended to reduce the volatility of an asset. If the hedging position behaves differently than expected, the volatility of the strategy as a whole may increase and even exceed the volatility of the asset being hedged.
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