Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

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Topic Author
Vision
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Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Vision » Mon Aug 12, 2019 7:33 am

EU investor, Lithuania.

Planning to in accumulating VWRA fund for equity portion of my portfolio.

It is Ireland based.

What could be potential issues long term with currency risk?

Can someone explain it in really simple terms, because so far I have not understood the "currency risk" for non-US investors.

Also, do you think VWRA is a solid choice?

It is accumulating, recently introduced, world stock index from Vanguard.

Prospectus:
https://americas.vanguard.com/instituti ... ##overview

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BeBH65
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by BeBH65 » Mon Aug 12, 2019 8:18 am

Sure does.
Currency risk is the risk of changes in the exchange rate between the currency of the investor and the currency of the asset.
VWRA has about 10% of its assets in EURO, all the rest is non-euro. Changes in the exchange rate with Euro would impact the value in Euro.

See also Non-US_investors_and_ETF_currencies; note that the currency of the fund does not enter in the currency risk.
Also the theory of purchasing power parity also plays here.
BeBH65. (only an investment enthusiast, not a financial adviser, perform your due diligence). | Have a look at https://www.bogleheads.org/wiki/Outline_of_Non-US_domiciles

Valuethinker
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Valuethinker » Mon Aug 12, 2019 9:55 am

Vision wrote:
Mon Aug 12, 2019 7:33 am
EU investor, Lithuania.

Planning to in accumulating VWRA fund for equity portion of my portfolio.

It is Ireland based.

What could be potential issues long term with currency risk?

Can someone explain it in really simple terms, because so far I have not understood the "currency risk" for non-US investors.

Also, do you think VWRA is a solid choice?

It is accumulating, recently introduced, world stock index from Vanguard.

Prospectus:
https://americas.vanguard.com/instituti ... ##overview
2 types of currency exposure:

- currency of denomination or reporting. The value of the constituent holdings is translated back into home currency (say EUR) on the valuation date.

Because the fund's actual investments might be in say USD movements in the exchange rate will matter.

Say the fund owns 100 MSFT (microsoft) shares at $100 each. That's $10,000. Say that equals EUR 10,000

Then the exchange rate moves to $1: 1.25 EUR. That investment is now worth EUR 12,500.

However if the fund was reporting in USD, it would not matter-- you'd have the same USD amount in the fund but it would be worth more in EUR. The change in exchange rate helps you if you are an EUR based investor no matter what currency the fund reports

- economic exposure

Say the fund hedges all its investments back into EUR. In the above example, the value of its investment increases to 12,500, but there is also a derivative contract (forward, future or option) in place that is now showing a loss of -2500 EUR. Thus the gain from the depreciation of the EUR no longer accrues to the investor.

The good news is that if say we went to EUR to USD 0.8, then the value of the investment falling from 10k EUR to 8k EUR, there would be an offsetting contract which would show a 2k EUR profit. So the total position would still be worth EUR 10k. An appreciation of the EUR did not hurt your investment.

In actual practice equity funds tend not to hedge currency. It is assumed that Purchasing Power Parity aka the Law of One Price holds in the long run. If the USD depreciates for a EUR investor, the value of US stocks will in the long run also go up, thus offsetting the effect.

By contrast bond funds do usually hedge currency. Because currency volatility is much greater than bond returns, a bond fund (international) that does not hedge currency is basically a currency speculation fund. And we believe here that that currency speculation adds volatility but with no commensurate increase in return - you are taking risk and not being paid for it.

Accumulating v. Distributing

You have to be careful of your tax laws. For a UK person one should never used Accumulation Units outside of a tax protected account.

Topic Author
Vision
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Vision » Mon Aug 12, 2019 12:28 pm

2 types of currency exposure:

- currency of denomination or reporting. The value of the constituent holdings is translated back into home currency (say EUR) on the valuation date.

Because the fund's actual investments might be in say USD movements in the exchange rate will matter.

Say the fund owns 100 MSFT (microsoft) shares at $100 each. That's $10,000. Say that equals EUR 10,000

Then the exchange rate moves to $1: 1.25 EUR. That investment is now worth EUR 12,500.

However if the fund was reporting in USD, it would not matter-- you'd have the same USD amount in the fund but it would be worth more in EUR. The change in exchange rate helps you if you are an EUR based investor no matter what currency the fund reports

- economic exposure

Say the fund hedges all its investments back into EUR. In the above example, the value of its investment increases to 12,500, but there is also a derivative contract (forward, future or option) in place that is now showing a loss of -2500 EUR. Thus the gain from the depreciation of the EUR no longer accrues to the investor.

The good news is that if say we went to EUR to USD 0.8, then the value of the investment falling from 10k EUR to 8k EUR, there would be an offsetting contract which would show a 2k EUR profit. So the total position would still be worth EUR 10k. An appreciation of the EUR did not hurt your investment.

In actual practice equity funds tend not to hedge currency. It is assumed that Purchasing Power Parity aka the Law of One Price holds in the long run. If the USD depreciates for a EUR investor, the value of US stocks will in the long run also go up, thus offsetting the effect.
I just don't understand it. Is there explain to me like I'm 5 version available?

ignition
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by ignition » Mon Aug 12, 2019 3:06 pm

Vision wrote:
Mon Aug 12, 2019 7:33 am
EU investor, Lithuania.

Planning to in accumulating VWRA fund for equity portion of my portfolio.

It is Ireland based.

What could be potential issues long term with currency risk?
If the euro strengthens relative to other currencies, your assets denominated in USD, yen etc. will decrease in value.
Vision wrote:
Mon Aug 12, 2019 7:33 am
Can someone explain it in really simple terms, because so far I have not understood the "currency risk" for non-US investors.

Also, do you think VWRA is a solid choice?

It is accumulating, recently introduced, world stock index from Vanguard.

Prospectus:
https://americas.vanguard.com/instituti ... ##overview
VWRA is good but the exposure to euro denominated assets is only 10%. You could consider hedging part of your equities using a euro hedged equity fund. The downside: these are usually more expensive (higher expense ratio) and hedging from the point of view of a euro based investor is expensive right now because of the lower short term interest rate in Europe compared to the US.

Topic Author
Vision
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Vision » Mon Aug 12, 2019 4:51 pm

If the euro strengthens relative to other currencies, your assets denominated in USD, yen etc. will decrease in value.
Yeah, but I don't know if EUR will strengthen or weaken, so....what difference does it make? You say I should hold 50/50 USD and EUR assets? But how to achieve that? Hold bonds in USD?

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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by dratkinson » Mon Aug 12, 2019 7:03 pm

I have a real world illustration of the effect of currency risk due to valuethinker's described currency of denomination or reporting.

For many years I had a Chinese penpal. At one point she had a sudden need that could be solved by money so I rounded up and sent (Western Union) her a little more than she needed (plan for the worst, hope for the best). Our understand was that I was sending her US dollars (USD) and that I was to be repaid in USD. (N.B. Her 0%-interest loan was USD-denominated. This agreement meant that I was removing my currency exchange risk, and she was bearing all of the currency exchange risk. She understood and agreed.)

At the time I sent the money, the CNY (Chinese yuan)|USD exchange rate was ~8.5|1*. So my $1000 USD loan became 8500 yuan for her. (* The rate had been stable for many years, so I didn't think there was much to worry about, for either of us.)

A few years later she had saved enough to repay me and the CNY|USD exchange rate had changed to ~6.5|1*. Meaning she only needed 6500 yuan to repay her $1000 USD-denominated debt. This was a good deal for her as the exchange rate had moved in her favor. (* The Chinese government had moved to strengthen its currency on the world market. Who knew.)

However, if the exchange rates had moved against her---she had borrowed 6500 yuan but had to repay 8500 yuan---she would have lost money.

Bottom line. If we are not expert at speculating in foreign currencies, then it's better to minimize/remove currency exchange risks.



I can't offer any suggestions for non-US investors.

However, I do recall Wiki does offer some suggestions. Can start here:
Non-US Domiciles: https://www.bogleheads.org/wiki/Outline ... _domiciles
Last edited by dratkinson on Mon Aug 12, 2019 7:51 pm, edited 1 time in total.
d.r.a, not dr.a. | I'm a novice investor, you are forewarned.

ivk5
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by ivk5 » Mon Aug 12, 2019 7:30 pm

This is a significant argument for a home country (currency) bias which you are challenging in your other thread, as noted in some of the posts and linked papers there.

glorat
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by glorat » Mon Aug 12, 2019 7:59 pm

The default recommendation is NOT to hedge the currency risk of your global equity portfolio.

For a globally connected region like Europe, you have EUR based companies making most of their earnings in non-EUR currencies (but reporting in EUR) and many non-EUR companies (Nestle comes to my mind) that earn significant EUR but report in CHF. Unlike fixed income, hedging is very imprecise in this situation. You'd have to do some careful analysis to see if hedging reduces volatility but for the average investor, why bother.

I believe people who worry about currency risk, instead tend to apply "home bias" to their equity portfolio.

eldinero
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by eldinero » Mon Aug 12, 2019 8:12 pm

Vision
You asked for simple version. I try (most of the above comments were correct, some little complicated)

- As an example when you invest in VWRA, your biggest investment is Microsoft (MSFT). It has revenues all over the world, and hedges and reports those in USD. You cannot control this. All multi-national companies do this. Most of your investments in VWRA are like this (excluding few solely small national companies)
- Most multi-nationals everybody can buy in Euro or USD, example Nestle (NSGRY) is listed both in EUR and USD. Because of the efficient markets it does not really matter if you buy in EUR or USD (unless you beat the eur/usd exchange rate, like George Soros 😊 )
- In summary, when you invest in VWRA you automatically take currency risk, like in investing in any multinational company (while the companies hedge this to their reports). But this is OK and is still the best strategy, and VWRA would be my choice if European
- Bonds instead in your currency (or hedged), because bonds mostly are not international like companies (bond funds can be, but I would be careful, depending on the risk profile)

andrew99999
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by andrew99999 » Tue Aug 13, 2019 3:25 am

glorat wrote:
Mon Aug 12, 2019 7:59 pm
The default recommendation is NOT to hedge the currency risk of your global equity portfolio.
I don't think that just because something is the "default" is a good reason to follow.
I have seen larege crowds of entire investment forums follow home bias, dividend investing, and a host of other nonsense. I will continue to stick with what makes sense to me instead of following what the default option is.

The "default" advice is based on the fact that currency risk is ok because
1. Eventually it turns around (this ignores that it can take a couple of decades to do this and you have to be able to tolerate it both financially and emotionally); and
2. As you age and your risk tolerance goes down, you are naturally lowering your currency exposure by gliding up your bonds. This may be true for people retiring at normal retirement age, retiring with 50% or more in bonds, and owning their own home lowering their home currency cash flow liabilities, but anyone falling outside that group is facing currency risk with their higher equities allocation.
glorat wrote:
Mon Aug 12, 2019 7:59 pm
I believe people who worry about currency risk, instead tend to apply "home bias" to their equity portfolio.
Probably right for some or even many people, but not for me. I worry about currency risk and it has nothing to do with home bias, it has to do with currency risk, which is a real thing.

silverex
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by silverex » Tue Aug 13, 2019 3:50 am

Vision wrote:
Mon Aug 12, 2019 7:33 am
EU investor, Lithuania.

Planning to in accumulating VWRA fund for equity portion of my portfolio.

It is Ireland based.

What could be potential issues long term with currency risk?

Can someone explain it in really simple terms, because so far I have not understood the "currency risk" for non-US investors.

Also, do you think VWRA is a solid choice?

It is accumulating, recently introduced, world stock index from Vanguard.

Prospectus:
https://americas.vanguard.com/instituti ... ##overview
Hi Vision, fellow Lithuanian here.

I'd say the currency risk of this Vanguard ETF is about the same as investing into any other (non-hedged) world stock ETF.

This fund is quite new, so there might be a bigger bid-ask spread on the exchanges, but it's not like you cannot buy or sell it - there are market makers which will always supply liquidity. Also, according to Vanguard, it's just the accumulating share class that is new - the fund itself is quite older and bigger.

Vanguard should be a solid choice - it's a non-profit company in US, although I've read that it's not the case with their European entity.

Topic Author
Vision
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I think I finally understood "currency risk". Did I get it right? And how to prevent it?

Post by Vision » Tue Aug 13, 2019 4:50 am

So I want to go with 80% VWRA / 20% some sort of bond index.

I understood if my assets are not 50%/50% EUR/USD based, then I can suffer from currency risk. For example, VWRA has only 10% of assets in EUR.

I have not yet decided on bond portion of my portfolio (any suggestions welcome).

But how do I bring down currency risk? How do I get my currency distribution to be closer to 50/50 while maintaining true world stock distribution in my equity part of portfolio?

Topic Author
Vision
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Vision » Tue Aug 13, 2019 5:00 am

Ok, I think I know what currency risk is now, but more important question - how do I prevent / hedge against it?

andrew99999
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by andrew99999 » Tue Aug 13, 2019 5:58 am

Vision wrote:
Tue Aug 13, 2019 5:00 am
Ok, I think I know what currency risk is now, but more important question - how do I prevent / hedge against it?
Better if you did not make another thread since it is the same topic.

Anyway, my thoughts are to consider what your assets will look like when you are retired.
If by then you will be up to at least 40% bonds, with the other 10% EUR based assets in your equities, you will be split down the middle already, so no need to do anything.
If you will retire early with a more aggressive allocation, or if you will be renting in retirement needing more home currency based returns for the higher home currency based liabilities, only then would you need to be concerned about currency risk.

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BeBH65
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by BeBH65 » Tue Aug 13, 2019 6:18 am

Vision wrote:
Tue Aug 13, 2019 5:00 am
Ok, I think I know what currency risk is now, but more important question - how do I prevent / hedge against it?
1. You only invest in assets of your currency, OR
2. You hedge your investments to fix the exchange rate.
there is a small cost to hedging.



It is important to understand that hedging works both ways. It removes the all volatility on the currency exchange.

Currently you get 1.12 USD for 1 Euro - hedging has the goal to keep this constant.
With 1000 Euro you get 1120 USD of US assets, today.
Assuming no change in the assetprice.
If you hedge you always get 1000 Euro back if you sell the assets.

If un-hedged,
- if the Euro raised to 1.230 USD you will get about 900 Euro back
- if the Euro drops to 1.010 USD you will get about 1100 Euro back
BeBH65. (only an investment enthusiast, not a financial adviser, perform your due diligence). | Have a look at https://www.bogleheads.org/wiki/Outline_of_Non-US_domiciles

alibaba123
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by alibaba123 » Tue Aug 13, 2019 8:35 am

silverex wrote:
Tue Aug 13, 2019 3:50 am
Vision wrote:
Mon Aug 12, 2019 7:33 am
EU investor, Lithuania.

Planning to in accumulating VWRA fund for equity portion of my portfolio.

It is Ireland based.

What could be potential issues long term with currency risk?

Can someone explain it in really simple terms, because so far I have not understood the "currency risk" for non-US investors.

Also, do you think VWRA is a solid choice?

It is accumulating, recently introduced, world stock index from Vanguard.

Prospectus:
https://americas.vanguard.com/instituti ... ##overview
Hi Vision, fellow Lithuanian here.

I'd say the currency risk of this Vanguard ETF is about the same as investing into any other (non-hedged) world stock ETF.

This fund is quite new, so there might be a bigger bid-ask spread on the exchanges, but it's not like you cannot buy or sell it - there are market makers which will always supply liquidity. Also, according to Vanguard, it's just the accumulating share class that is new - the fund itself is quite older and bigger.

Vanguard should be a solid choice - it's a non-profit company in US, although I've read that it's not the case with their European entity.

Please tell me more about how their European entity is profit making? I am only sticking with VWRD and the 0.25% expense ration because i have thought all along their structure is just like Vanguard US whereby the investors own the company.

ignition
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by ignition » Tue Aug 13, 2019 8:41 am

Vision wrote:
Mon Aug 12, 2019 4:51 pm
If the euro strengthens relative to other currencies, your assets denominated in USD, yen etc. will decrease in value.
Yeah, but I don't know if EUR will strengthen or weaken, so....what difference does it make? You say I should hold 50/50 USD and EUR assets? But how to achieve that? Hold bonds in USD?
Did you read the second part of my post? I'll repeat: you can hedge a part of your equity allocation by buying a euro-hedged equity fund (such as IWDE).

I didn't specifically state how much you should hedge. That is above my pay grade I'm afraid as it is pretty hard to forecast the future :wink: . I guess 50/50 is a good starting point. If the euro goes up: fine you've hedged 50% of your portfolio.

Disclaimer: I'm also from Europe but don't hedge my equities. I am considering to hedge a part of my equities when I start withdrawing from my portfolio. It also depends on how many bonds you have. If 50% of your portfolio is in euro bonds or euro hedged bonds, you probably don't need to hedge your equities.

silverex
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by silverex » Tue Aug 13, 2019 8:58 am

alibaba123 wrote:
Tue Aug 13, 2019 8:35 am

Please tell me more about how their European entity is profit making? I am only sticking with VWRD and the 0.25% expense ration because i have thought all along their structure is just like Vanguard US whereby the investors own the company.
I don't have any details - except some mentions on forums. On https://www.vanguard.co.uk/adviser/adv/ ... d/about-us it's stated that "The Vanguard Group, Inc. is owned by its US-domiciled funds, which are owned by their shareholders.", but it doesn't say anything about non-US funds, which seem to be owned by Vanguard Asset Management Ltd. (https://www.ft.com/content/ced14430-625 ... c7eb84e5f1 - link from Google works). I'm not stating that European entity is for-profit, all I'm saying that it doesn't seem to have the same ownership structure as US funds. Maybe it would be best to ask Vanguard directly!

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BeBH65
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by BeBH65 » Tue Aug 13, 2019 9:05 am

alibaba123 wrote:
Tue Aug 13, 2019 8:35 am
silverex wrote:
Tue Aug 13, 2019 3:50 am
Vanguard should be a solid choice - it's a non-profit company in US, although I've read that it's not the case with their European entity.

Please tell me more about how their European entity is profit making? I am only sticking with VWRD and the 0.25% expense ration because i have thought all along their structure is just like Vanguard US whereby the investors own the company.
I would not say that Vanguard Group is a non-profit organisation. Non-profit organisations have a very specific structure and have to abide to specific rules.

My understanding is that Vanguard US is a (for-profit) organisation where the shareholders are the (US) funds. As such Vanguard does not strive to maximize profit, growth or alike, and certainly not to the detriment of their funds or the people investing in their funds. Basically, For Vanguard (US), running break-even is sufficient.

Vanguard Europe is a subsidiary of Vanguard Group.

For more info see e.g.
https://global.vanguard.com/portal/site/kiids/be/en/about-vanguard wrote:The Vanguard Difference

Stability and experience
What sets Vanguard apart – and lets Vanguard put investors first around the world – is the ownership structure of The Vanguard Group, Inc., in the United States.

Rather than being publicly traded or owned by a small group of individuals, The Vanguard Group is owned by Vanguard's U.S.-domiciled funds and exchange-traded funds (ETFs). Those funds, in turn, are owned by their investors.

This unique mutual structure aligns our interests with those of our investors and drives the culture, philosophy and policies throughout the Vanguard organisation worldwide.

In Europe, Vanguard leverages the scale, experience and resources of our established global business. Vanguard's ownership structure means that our clients don't have to worry that we'll be acquired. The company they invest with today will continue to serve them in the future.

Low-cost-investing
Investors can’t control the markets, but they can control the costs of investing. Providing low-cost investments isn't a pricing strategy for us. It's how we do business.

We can keep costs low because of our unique ownership structure in the United States, which allows us to return profits to investors through lower costs.

Vanguard’s scale also helps to keep costs low. As our assets under management increase, we can reduce expense ratios for the investors in our funds globally.

Client focus
The ownership structure of our parent company, The Vanguard Group, aligns our interests with those of our clients. Because Vanguard is not publicly traded, we can extend the benefits of that structure to our clients in Europe.

From rigorous risk management to transparent pricing to plain talk communications, we put our clients' interests first.

Everything we do at Vanguard is designed to give our clients the best chance for investment success.
BeBH65. (only an investment enthusiast, not a financial adviser, perform your due diligence). | Have a look at https://www.bogleheads.org/wiki/Outline_of_Non-US_domiciles

Topic Author
Vision
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Vision » Tue Aug 13, 2019 10:43 am

Ok, so I guess for now it makes most sense for me to hedge with an EUR based bond index, correct? But which one? I want it to be accumulating.

Valuethinker
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Valuethinker » Wed Aug 14, 2019 8:55 am

Vision wrote:
Mon Aug 12, 2019 7:33 am
EU investor, Lithuania.

Planning to in accumulating VWRA fund for equity portion of my portfolio.

It is Ireland based.

What could be potential issues long term with currency risk?

Can someone explain it in really simple terms, because so far I have not understood the "currency risk" for non-US investors.

Also, do you think VWRA is a solid choice?

It is accumulating, recently introduced, world stock index from Vanguard.

Prospectus:
https://americas.vanguard.com/instituti ... ##overview
Sorry my explanation was too complicated.

If the Euro rises against the dollar (more dollars to buy 1 Euro) then as an investor:

- your Euro assets are worth more
- your dollar assets are worth less

Similarly the reverse - if 1 dollar buys more Euros (1 Euro buys fewer dollars) then

- your Euro assets are worth less
- your dollar assets are worth more

"Currency hedged" funds offset this effect. Otherwise it will affect the relative valuations of your investments - even if they have a reporting currency of Euros, say.

We tend here to say:

- most of us have an income (job) in our home currency (Euros in your case)
- most of us probably own a property in our home country (again home currency)
- as we move towards retirement we hold more bonds

This means by holding the global equity portfolio (currency unhedged) we diversify as much as possible away from a personal balance sheet whose 2 main assets (property equity & expected future income from work) that is pretty much entirely in our home currency (GBP in my case).

So
- bond funds we tend to hedge currency, because otherwise the volatility of currencies is far more than the returns from the bonds
- equity funds we tend not to hedge currency because 1. hedging has a cost 2. in the long run we think it should all work out and the currency should find the "right" level (that makes the costs of things the same in every country, less different transport costs, VAT etc - a Chinese made computer should be the same price in the Eurozone as it is in the USA), The same effect should work in the long run for stocks.

What Andrew9999 points out is that that last point is not a given truth. If your time horizon to retirement is 10 years or less (definitely) or 20 years (maybe) one should consider also hedging currency on one's global equity funds - buying ones that strip out the exchange rate risk.

glorat
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by glorat » Wed Aug 14, 2019 10:04 am

Regarding currency hedging, I have a different view from both the above.

I believe that removing currency risk would be a good thing (so I agree with andrew and valuethinker on that)

However, I believe that currency hedging of equity portfolios neither works in theory nor practice

1) Theory - the fund manager can only hedge the declared earnings of global companies. But the global companies themselves are earning global income that may or may not be hedged to their reporting currency. You have a 50% chance the hedge is hedging, and 50% chance you're doubling up on a hedge and making a mess

2) Practice - Returns. How many global hedged equity funds have worked out for the investor? Especially for EU, I'd wager none

3) Practice - Risk. How many global hedged equity funds have reduced volatility for the investor? I've looked everywhere and found none, except maybe Australia

My personal conclusion: There is no risk/reward benefit in hedging a global equity fund. (But plenty of theory and evidence to show it is good for fixed income)

Edit: I just did a google for "hedging global equity fund" and this link came up https://www.ft.com/content/20104c9e-58f ... ceb45fa9d0 . Ouch

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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by Valuethinker » Wed Aug 14, 2019 10:31 am

glorat wrote:
Wed Aug 14, 2019 10:04 am
Regarding currency hedging, I have a different view from both the above.

I believe that removing currency risk would be a good thing (so I agree with andrew and valuethinker on that)

However, I believe that currency hedging of equity portfolios neither works in theory nor practice

1) Theory - the fund manager can only hedge the declared earnings of global companies. But the global companies themselves are earning global income that may or may not be hedged to their reporting currency. You have a 50% chance the hedge is hedging, and 50% chance you're doubling up on a hedge and making a mess
The manager hedges the *value* of portfolio holdings back into the home currency. That still works, regardless of the hedging strategy of the company.

A company cannot hedge its stock price in the home currency. An investor can. If the company hedges its earnings:

- it usually does not do 100% and the hedges are not out to all possible dates in the future, they usually only hedge relatively short term currency exposure (the longer the hedge, the more expensive it can be)
- the market prices the stock based on expectations of earnings including the hedging
2) Practice - Returns. How many global hedged equity funds have worked out for the investor? Especially for EU, I'd wager none
If your currency has risen against another currency and you are an international investor, it is worth it to hedge. So for example US investors (investing internationally) since the GFC -- the dollar has appreciably strengthened especially against the Euro and the Pound Sterling.

I don't have a good estimate on the cost of hedging to an equity (or bond) fund, unfortunately. I believe it to be quite small.
3) Practice - Risk. How many global hedged equity funds have reduced volatility for the investor? I've looked everywhere and found none, except maybe Australia
Plenty of academic research and for institutional investors shows that hedging back to your home currency reduces volatility and can improve the risk-return tradeoff.
My personal conclusion: There is no risk/reward benefit in hedging a global equity fund. (But plenty of theory and evidence to show it is good for fixed income)

Edit: I just did a google for "hedging global equity fund" and this link came up https://www.ft.com/content/20104c9e-58f ... ceb45fa9d0 . Ouch
I'd have to read the FT article (it is paywalled).

In an institutional context, the currency hedging strategy is set *separately* from the fund investing. If you are a UK pension fund, you can do a "currency overlay" to whatever percentage you want.

So there is no distinction hedging equity v hedging debt.

Your different fixed income and equity managers are tasked with beating their benchmarks in the currency of that benchmark - Japanese Yen, Euro, USD etc.

Separately, you or the firm managing the currency overlay uses derivatives (futures, forwards, options) to set the currency allocation. If 70% of your assets are in non UK markets, and your currency target is 50/50, you would "short" the currency exposure of 20% of your assets (that will change every day) to get you to the 50% level.

glorat
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by glorat » Wed Aug 14, 2019 10:46 am

Your points are well made so there is a good chance I'm simply wrong on this. The scientific method can be applied... my points 2) and 3) are easily disprovable if wrong so I'm happy to be shown to be wrong.
Valuethinker wrote:
Wed Aug 14, 2019 10:31 am
So there is no distinction hedging equity v hedging debt.
My theory on hedging is the the value of any financial asset (equity or debt or other) is the sum of all cashflows generated by the asset, discounted to present day. Fixed income cashflows are all in known currencies so can easily be hedged precisely and fully at low cost.

Equity cashflows - well it depends on your granularity. If at the company value level, sure you can hedge at that level. But a company value (or share price) is based on the sum of all company future cashflows (in and out) of the company, discounted to present day. Those cashflows are typically cross currency for large caps, and companies may or may not hedge those to their reporting currency.

This theory is testable. If hedging company level valuations works in reducing portfolio risk, then it implies that most companies are already largely either hedged or majorly earning in their reporting currency. This may indeed be a true case, in which case, sure, hedging at that level of the portfolio earnings will work for investors

silverex
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by silverex » Wed Aug 14, 2019 11:17 am

alibaba123 wrote:
Tue Aug 13, 2019 8:35 am

Please tell me more about how their European entity is profit making? I am only sticking with VWRD and the 0.25% expense ration because i have thought all along their structure is just like Vanguard US whereby the investors own the company.
I've got this statement from Vanguard UK:
Vanguards European business is a wholly owned subsidiary of the US business. Therefore we have the same commitment to our
clients and the same principles of keeping costs low.

Over its time in Europe Vanguard has lowered the costs of our funds several times as we continue to grow and develop our
European offering. As we scale we can continue to do this and give all our investors the best chance of investment success.

You can read more about us here: https://www.vanguardinvestor.co.uk/why- ... experience
I still think the structure is not replicated from US, but probably that doesn't make any practical difference.

ignition
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by ignition » Thu Aug 15, 2019 4:07 am

glorat wrote:
Wed Aug 14, 2019 10:04 am
2) Practice - Returns. How many global hedged equity funds have worked out for the investor? Especially for EU, I'd wager none
With the euro and sterling falling against the dollar it is logical currency hedged funds have underperformed funds that didn't currency hedge.

If you look from the point of view of an American investor, currency hedging international equities would have improved returns over the same period (for example compare ticker HEFA with EFA: https://www.portfoliovisualizer.com/bac ... 0&total3=0).
glorat wrote:
Wed Aug 14, 2019 10:04 am
3) Practice - Risk. How many global hedged equity funds have reduced volatility for the investor? I've looked everywhere and found none, except maybe Australia
Have you read the paper by Vanguard mentioned in this topic: viewtopic.php?t=258721
glorat wrote:
Wed Aug 14, 2019 10:04 am
My personal conclusion: There is no risk/reward benefit in hedging a global equity fund. (But plenty of theory and evidence to show it is good for fixed income)

Edit: I just did a google for "hedging global equity fund" and this link came up https://www.ft.com/content/20104c9e-58f ... ceb45fa9d0 . Ouch
Of course currency hedged funds would have badly underperformed non currency hedged funds for a UK investor with the pound weakening so much after Brexit.

glorat
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by glorat » Thu Aug 15, 2019 4:32 am

ignition wrote:
Thu Aug 15, 2019 4:07 am
Have you read the paper by Vanguard mentioned in this topic: viewtopic.php?t=258721
I have not read that... until now. This goes a long way to changing my opinion, thank you for sharing.

At this point, I'm happy to concede I'm mistaken on the points about returns (it's 50/50 depending on which side of the rising/falling currency you are) and clearly there is evidence to support hedging global equities as having a useful effect.

I think my first principle theoretical point still stands though. As evidence/example of it, the returns of the FTSE100 is purely in GBP of course but has a GBP/USD FXDelta of about 0.7 (IIRC). In other words, a 1% drop in GBP (vs the dollar) causes a 0.7% rise in the value of the FTSE100. When a US investor has exposure to the FTSE100, what are they hedging? If hedging the value of the FTSE100, they will end up over-hedging since the FTSE100 companies were earning (in simplified terms) an unhedged majority of their earnings in USD anyway.


ignition
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Re: Can someone explain to me "currency risk" in case of EU investor? Does it apply to VWRA?

Post by ignition » Fri Aug 16, 2019 3:38 am

glorat wrote:
Thu Aug 15, 2019 4:32 am
ignition wrote:
Thu Aug 15, 2019 4:07 am
Have you read the paper by Vanguard mentioned in this topic: viewtopic.php?t=258721
I have not read that... until now. This goes a long way to changing my opinion, thank you for sharing.

At this point, I'm happy to concede I'm mistaken on the points about returns (it's 50/50 depending on which side of the rising/falling currency you are) and clearly there is evidence to support hedging global equities as having a useful effect.
Yes, and it also depends on short term interest rates. If short term interest rates are higher in the US than in Europe, it will cost you more to hedge USD as a European investor since you have to pay interest on the contract. Also hedging is never perfect as one month forward contracts are used in most cases and equity values can of course fluctuate quite a bit even over 1 month.

Let me be clear: I wouldn't advise hedging all of your equities as indeed currency fluctuations can move both ways but I think it makes sense to hedge part of your equities, especially when you have a high equity allocation and are globally diversified. What is holding me back at the moment is the big short term interest rate difference between Europe and the US which is unfavorable for euro based investors at the moment and the higher TER of currency hedged funds.
glorat wrote:
Thu Aug 15, 2019 4:32 am
I think my first principle theoretical point still stands though. As evidence/example of it, the returns of the FTSE100 is purely in GBP of course but has a GBP/USD FXDelta of about 0.7 (IIRC). In other words, a 1% drop in GBP (vs the dollar) causes a 0.7% rise in the value of the FTSE100. When a US investor has exposure to the FTSE100, what are they hedging? If hedging the value of the FTSE100, they will end up over-hedging since the FTSE100 companies were earning (in simplified terms) an unhedged majority of their earnings in USD anyway.
I am not sure if this is true.

Let's says you have 100£ of FTSE100 shares. The GBP/USD rate is 1.2. A US investor would have 120$ worth of shares.

GBP/USD falls 1% to 1.188 and the FTSE100 rises because of this to 100.7£. A UK investor would have gained 0.7£ or 0.7%.

A US investor on the other hand would have lost 0.37$ if he didn't hedge ((100.7£*1.188) - (100£*1.2)) = -0.37$

If he did hedge he would have gained 0.84$ ((100.7£ * 1.2) - (100£ * 1.2)) = 0.84$ or 0.7%. The same gain as the UK investor.

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