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Hedged ETFs Provide Foreign Exposure Sans Currency Risk

By DailyAlts Staff A new whitepaper from Deutsche Asset & Wealth Management (Deutsche AWM) considers the benefits of using currency-hedged ETFs (exchange-traded funds) to gain foreign equity exposure. Written by Deutsche AWM ETF strategists Dodd Kittsley and Abby Woddham, the paper explores the growth of investor interest in foreign stocks and the ETFs that hold them, as well as considering the potential “currency risk” of holding unhedged foreign equities. Foreign Investment Difficulties Investing in foreign stocks has been difficult historically for a variety of reasons. First and foremost, most foreign stocks trade on foreign exchanges, and domestic investors inherently have reduced access to foreign exchanges. Furthermore, stocks trading on foreign exchanges are priced in foreign currencies, creating an intermediary requirement (and hassle) for U.S. investors to first exchange dollars for foreign currencies, and also creating the phenomenon of “currency risk” – the risk that exchange rates between the dollar and the foreign currency will change during the holding period of the foreign stock. Overcoming Those Difficulties Over time, these difficulties have been addressed one by one. First, the number of foreign stocks trading on U.S. exchanges has increased steadily over time, including Alibaba’s record-breaking IPO last year. Secondly, U.S. investor access to foreign exchange markets has increased – but even more significantly, the rise of ETFs that hold stocks trading on foreign exchanges has greatly expanded investor access to such stocks. Indeed, the low cost, tax efficiency, liquidity, and transparency of ETFs has made them perhaps the most popular means of gaining foreign equity exposure. But for “unhedged” foreign stock ETFs, the phenomenon of currency risk remains – and it can have a devastating impact on an investment’s results. An Example of Currency Risk Deutsche AWM’s whitepaper offers the following example as evidence: Imagine you wanted to buy $150,000 of a stock trading on a German exchange, with the stock’s shares priced in euros. Suppose the exchange rate at the time of the purchase was $1.50 to 1 euro, and therefore $150,000 would buy 100,000 euros worth. Now imagine that a year later, the stock price is flat, and you therefore still have 100,000 euros worth of shares – but unfortunately, the dollar has strengthened against the euro so that $1 equals 1 euro. In this case, your 100,000 euros worth of stock, that you paid $150,000 for a year earlier, would now be worth just $100,000. Due to currency risk, an investment that would have resulted in a breakeven return became a 33% loss. This is illustrated below: (click to enlarge) How Currency Hedging Works In response, ETF providers have developed “currency-hedged” products. These ETFs hold shares of stocks priced in foreign currencies, but they use forward currency contracts to “hedge” against currency risk. This is done by agreeing to sell the foreign currency at the current exchange rate sometime in the future – if, in the example above, you would have agreed to sell 100,000 euros for $150,000 one year in the future at the same moment you bought 100,000 euros worth of stock; then a year later, your stock would still be flat at 100,000 euros, but instead of losing 33% to currency fluctuations, your forward contract would offset that loss with a 33% gain. You could sell your shares for 100,000 euros, but instead of exchanging them for $100,000 at the current exchange rate, your forward contract would entitle you to sell them for $150,000. Conclusion The authors of Deutsche AWM’s paper point out that currency risk is a blade that can cut both ways: Japanese stocks were up 54.6% in 2013 when priced in yen, but only 27.2% when priced in dollars due to the dollar strengthening against the yen that year. But when Japanese stocks only gained 0.6% in 2010 priced in yen, they gained 15.4% that same year priced in dollars due to the yen’s strengthening against the dollar that year. Since exchange-rate changes can have either positive or negative impacts on an investment’s value, the whitepaper’s authors suggest strategically choosing “to hedge or not hedge” based on the outlook for the particular currencies involved. But with the dollar widely expected to strengthen in 2015 as the Federal Reserve begins raising interest rates, currency-hedged ETFs may be particularly worth the consideration of investors seeking exposure to foreign stocks. For more information, download a pdf copy of the whitepaper .

Falling U.S. Inflation Could Drive Up SLV

The price of SLV rallied by 5% during the year, up to date. Falling U.S. inflation may pull up SLV via the drop in U.S. treasury yields. The recent Non-farm payroll was inline with market expectations, but it didn’t drag down SLV. After losing nearly 8% during the last quarter of 2014, the iShares Silver Trust ETF (NYSEARCA: SLV ) showed some signs of recovery as its price added over 5% during this month. Even the strong results from the last non-farm payroll report didn’t curb down the price of SLV from picking up. Let’s review the relation among the developments in the U.S. labor market, inflation and the progress of SLV. The non-farm payroll report was published on Friday. It showed a 252 thousand of jobs added during December. Moreover, the previous two months were revised up by 50 thousand jobs. The rate of unemployment slipped to 5.6%. The table below shows the changes in SLV and the non-farm payroll results in 2014. Source of data taken from Bureau of Labor Statistics As you can see, the correlation between the changes in the gap between market projections and actual figures and the price of SLV is mid-strong and negative at -0.45 – this result suggests that as long as the number of jobs added doesn’t exceed market expectations, the price of SLV is likely to rally. Despite the recent rise of SLV last week, the ongoing recovery of the U.S. labor market doesn’t play in favor of SLV. This recovery, however, still has a long way to go until the U.S. labor market shows a full recovery – mainly in wages. Based on the recent report, hourly wages grew by only 1.7% on an annual pace. This is still a low level and remains well below the levels recorded before the 2008 economic meltdown. The other major report related to the U.S. labor market is the upcoming JOLTS report, which will be published this week. (click to enlarge) Source of data taken from Bureau of Labor Statistics Albeit the price of SLV doesn’t have as strong relation to the JOLTS figures as it does with the non-farm payroll. This is still an important report that could indicate the progress of the U.S. economy. The current estimates are for the report to show a 4.91 million jobs opening. The upcoming U.S. CPI and PPI, which will be released this week, could provide another measurement about the changes of the U.S. inflation. If the U.S. core inflation continues to slowly come down, this doesn’t vote well for rise in U.S. wages. The fall in U.S. inflation, however, could actually play in favor of SLV. At the very least, it may play this year in two roles when it comes to SLV. Usually, lower inflation tends to steer away investors, who fear of a potential spike in inflation, from precious metals investments such as SLV. The chart below presents the relation between core CPI and SLV during 2013-2014. Source of data taken from Bureau of Labor Statistics and Google finance Most of the drop in U.S. inflation was stemmed, as you well know, from falling oil prices. During the past few months, the correlation between SLV and oil prices was mid-strong and positive at 0.4. Albeit the price of SLV remained relatively flat, oil prices tumbled down by more than 40% in the past three months. So why falling oil prices could actually be good for SLV? As U.S. inflation falls, this is likely to reduce the odds of the FOMC raising rates. For now, the market still expects the FOMC to raise rates by the middle of the year. Alas, if U.S. inflation does tumble down, it could eventually influence FOMC members to reevaluate their policy. Finally, falling U.S. inflation is also likely to keep down U.S. long term treasuries yields, which tend to have a negative relation with the price of SLV. Therefore, falling long term treasuries yields driven, in part, by lower inflation provide the environment needed to keep pulling up SLV. For more see: Choosing Between Gold and Silver

Lack Of U.S. Wage Growth Puts These ETFs In Focus

The U.S. is creating jobs fast, but is slow in boosting wage growth. While the buzz about poor wage growth has been doing rounds for long, the unexpected and steepest fall in average U.S. hourly wage for December since 2006 cast a dark cloud over the country’s economic growth story. Average hourly earnings dipped 0.2% sequentially in December, and November average hourly earnings were adjusted down to a 0.2% increase. On a year-over-year basis, average hourly earnings in December were up 1.7%. This indicates that the brighter overall job picture was courtesy of the low-wage category. Thanks to this downbeat data, positive sentiments that shaped up over the U.S. investing in last few months, suffered a brief (seemingly) setback to start 2015. The U.S. dollar dipped against the yen, though slightly, following not-so-enthusiastic payrolls. Several emerging market currencies, however, including Taiwan’s dollar and Indonesia’s rupiah had witnessed a notable ascent following the payroll data. The WisdomTree Emerging Currency ETF ( CEW) , which provides a diversified play on emerging market currencies, added 0.24% on January 9th. Added to this is the inflationary outlook, which will likely remain grave in the days to come due to the unending oil rout. In fact, a beneficial driver like lower greenback also failed to perk up oil investing. Bloomberg analysts envisaged that U.S. consumer prices possibly grew 0.7% year over year in December, the five-year lowest. Most of the market participants started to believe that a solemn inflationary picture and a lackluster wage scenario will delay the hike in U.S. interest rates. We expect this shaky investor sentiment to take charge of the market movement at least for a few days. An upbeat economic data report is urgently needed to lift investors’ mood which is already sinking due to global growth worries. Greenback Gives Up Given the change in the market fundamentals and slide in the greenback following the latest wage data, investors might think about shorting U.S. dollars to take advantage. PowerShares DB U.S. Dollar Bearish Fund (NYSEARCA: UDN ) This fund could be the prime beneficiary of the falling USD as it offers exposure against a basket of world currencies. These include the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. This is done by tracking the Deutsche Bank Short U.S. Dollar Index Futures Index Excess Return plus the interest income from the fund’s holdings of U.S. Treasury securities. In terms of holdings, UDN allocates nearly 57.6% in euros while 25% collectively is in Japanese yen and British pounds. All of these currencies nudged up after the U.S. wage growth report. The $37.1 million fund charges 80 bps in fees a year from investors. This ETF was up 0.5% on January 9 but failed to sustain the gains after hours. Tilt to Treasuries Like 2014, the 10-year Treasury note too was off to a great start this year with yield slipping even below 2% since October. Notably, this was the best yearly start treasuries experienced in 17 years thanks to a spike in market volatility. Demand for 30-year treasury bonds was so high that yields plunged to the lowest level since July 2012. Investors seeking to ride this environment might take interest in iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) . This ultra-popular long-term Treasury ETF with an asset base of $6.6 billion – TLT – has added more than 4% so far in the New Year. TLT charges 15 bps in fees. Glitters of Gold After a tumultuous 2014, gold finally heaved a sigh of relief. Soft global growth, persistent plunge in oil and now the prospect of a delayed rate hike in the U.S. returned the shine of the yellow metal. On January 9, the SPDR Gold Trust ETF (NYSEARCA: GLD ) – the product tracking gold bullion -added about 1.14%. In the year-to-date frame, this $27.6 billion fund was up 3.2%. The ETF charges 40 bps in fees. Bottom Line As a caveat, investors should note that the outlook is quite rough for the inverse dollar and gold ETF. This is more the case for UDN, which tracks the greenback against currencies like the presently nine-year low euro. These ETFs will turn out winners as long as volatility and downbeat sentiments over the U.S. market prevail. Thus, investors need to be aware of the market at large before considering these investment options.