When to use a currency-hedged ETF

Last week, iShares launched Europe's first currency-hedged exchange-traded funds (ETFs). These allow investors to remove the currency risk component from three popular global equity indices: the MSCI Japan (available in a euro-hedged version only), MSCI World, and the S&P 500 (these are offered in both sterling- and euro-hedged versions).

The advantage of currency hedging is that you can split the investment decision regarding the underlying market from your view on its currency. Want to buy US shares, but concerned about the dollar? Buy a hedged S&P 500 fund. Feel that Japan's stockmarket is bottoming, but worried that the yen is vastly overvalued? Consider the hedged MSCI Japan ETF.

But you can look at these things the other way round, too. I've been an investor in Lyxor's Japan Topix ETF since early 2008. In domestic currency terms the Topix is well down since then. But as a sterling-based investor I'm actually up on my purchase price, due to the pound's weakness over the same period. If I'd bought a currency-hedged Japanese fund, I'd have foregone all those FX gains.

Currency hedging can also cost money if you're hedging from a high-interest rate currency to a lower-rate one (though you pick up a premium if it's the other way around). But with near-zero rates in most major FX blocs, this isn't a major concern right now. You also need to beware being sold the right product at the wrong time. In the US ETF market, for example, there was a clamour for funds offering currency-hedged exposure to foreign stocks earlier this year as the euro collapsed to $1.18. But you'd have missed out on a 17% rally in the euro since May if you'd followed the majority view.

All of this means that even if you're buying a currency-hedged investment, it's not sufficient just to have a view on the underlying market: you need to consider the currency regardless. But these new funds are still a valuable addition to investors' ETF armoury. If you feel that global stockmarkets are due a bounce, but also that sterling is so beaten up that it, too, may recover, then a currency-hedged fund is an ideal choice.

Paul Amery edits www.indexuniverse.eu .