Importance of Currency Hedging Foreign Investments

Makati, Philippines

Education, they say, is expensive. A lack of education, apparently, can be a lot more expensive.

Over the past two years I started to stray from my more rigid investment plan and asset allocation and began to trade with the exuberant hubris that has been the downfall of many a young investor; though that’s perhaps a story for another time.

Thankfully for the most part this has been lucrative, though I imagine at some point I will look back at the risks I took with the wincing hindsight we’ve all experienced after waking up the morning after doing something rather dimwitted the night before.

What this period did educate me on, however, is the importance of separating the currency out of foreign investments and treating them as a separate asset class.

In the summer of 2016, as populist politics swept across the globe, I spent a lot of time down in Indonesia and The Philippines and was struck with the great idea that I was on to some secret that these places would have incredible growth over the next five to ten years.

With Duterte newly installed in the driving seat of Philippines, and Jokowi and Ahok running things in Indonesia, I felt pretty confident that my due diligence was done and set off to find ETFs that track those markets.

With my account trading in USD, and not wanting to face the currency risk of trading in the local currencies, I found a couple of USD denominated ETFs and jumped in with my hard earned cash.

Fast forward 15 months and let’s see where we are:

Philippines Stock Market is up around 6.65%

Philippines Composite Index
Philippines Composite Index

Indonesian Stock Market is up around 6.59%

Jakarta Composite Index
Jakarta Composite Index

Admittedly, not the stellar returns I was hoping for, but certainly not bad.

So, how did the investment funds do over the same time period?

Philippines Stock Market ETF – $EPHE:   -4.61%
Indonesian Stock Market ETF – $EIDO:    2.68%

Shocked Emoji

Somehow the funds appear to have substantially under-performed their underlying benchmark.

So what happened?

Expense Ratios

Firstly, let’s check the Expense Ratio of the funds:

$EIDO:  0.63%
$EPHE: 0.64%

Whilst they are both higher than I would like (anything above 0.5% is too high in my opinion), they’re not big enough to cause such a huge gap.

Currency Risk

Lets see what happens when we plot the USD vs Local currency over the graphs, along side the ETFs and the Indexes:



As we can see from the graphs, the Indonesian Rupiah weakened against the Dollar by -2.70%, whilst the Philippine Peso fell by a staggering -8.51% over the same period.

It’s also fairly intuitive to eyeball the blue line on the graphs and notice that the funds stray from the index as the blue line strays from the zero line.

For example in the first few months of the graphs, a stronger Indonesian Rupiah pushed the fund above the index for a while.

In the Philippines, well, the Peso went down much like one assumes the employment prospects of a human rights lawyer have over there.

Key Takeaway

So, what can we learn from this?

That’s easy.
If you intend to invest in a foreign market, be sure to separate the currency as an asset class and appropriately hedge against it.

In this case, had I taken a short position against the Indonesian Rupiah and the Philippine Peso equal to the size of my equity positions, then I would have been protected from the downside in the currency and exposed only to the underlying equities risk.

However, had the currency moved in the opposite direction, I would not have benefited from the additional upside of the currency trade.

If you do intend to trade a particular market, perhaps reassess why you are making the trade and if the exposure to the currency risk is something you would like to bear in addition to the exposure to the underlying equity.

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