Currency Hedging Takes on New Urgency

Investment spotlight

Currency hedging takes on new urgency

By Larry Adam | Chief Investment Strategist—Americas

For the past decade U.S. investors were not as EQPEGTPGFYKVJEWTTGPE[ɧWEVWCVKQPUYJGP participating in international markets because the dollar was usually declining against the local currency of the country in which they had invested. U.S. investors were often rewarded with enhanced overall returns because of local currency strength and U.S. dollar weakness.

6JGGɥGEVUQHEWTTGPE[QPKPVGTPCVKQPCNKPXGUVOGPVU 6JGɦTUVFGECFGQHVJGOKNNGPPKWOYCUPQVMKPFVQ U.S. equity investors. From January 31, 2000 to January 30, 2009, the S&P 500 Index (including dividends) declined by approximately 30.3%1, or -3.9% on an annualized basis.

In Canada, however, rising commodity prices There was a time, not so long ago, when buoyed both that country’s economy and stock a majority of American investors invested market. The S&P/TSX Composite Index rose approximately 23.1%, including dividends. solely in U.S. securities. Today, U.S. In addition, the Canadian dollar appreciated 17% investors are allocating an increasing versus its U.S. counterpart2, thereby giving U.S. slice of their asset allocation pie to both investors fortunate enough to have participated in developed international and emerging the Canadian index a super charged return. In fact, the S&P/TSX Canadian Index in U.S. dollar terms market equities. actually gained 44.65%2, or 4.2% annualized.

Exhibit A Contribution to MSCI EAFE Index return from currency (1983-2012)

30% 2QVGPVKCNTGVWTPKORCEV5KPEGCUKIPKɦECPVRQTVKQPQHKPVGTPCVKQPCNGSWKV[ 25% return has come from currency moves, which can be positive or negative. 20% 15% 10% 5% 0% –5% –10% –15% –20% 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Positive contribution from currency Negative contribution from currency

Source: Bloomberg Finance LP as of 12/31/12. Performance is historical and does not guarantee future results.

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As a further illustration, consider the reverse of this The tide may be turning transaction. Canadian investors participating in the The United States is showing signs of an ongoing S&P 500 lost not only the 30.3% by which that index economic recovery, and, in our opinion, the United declined, but 17% because of unfavorable currency States has better fundamentals than its developed ɧWEVWCVKQPUHQTCVQVCNTGVWTPQH1 or -5.6% on market counterparts. Our forecast for GDP growth an annualized basis2. next year is 3.2% versus 1.0% for the Eurozone and 0.6% for Japan. The housing sector recovery, a Some investors use American Depository Receipts stronger U.S. consumer due to deleveraging, a slowly (ADR) to gain exposure to international stocks. improving labor market and nascent signs of a pick However, it is important to note that ADRs are not up in capital spending all support this view. hedged vehicles. Many investors believe currency risk can be avoided or mitigated through the use of The U.S. Federal Reserve Board’s recent decision to #&4UYJKEJCTG75FQNNCTFGPQOKPCVGFEGTVKɦECVGU likely slow its monetary purchases of government KUUWGFD[75DCPMUTGRTGUGPVKPICURGEKɦGF bonds and mortgage-backed securities adds number of shares in a foreign stock traded on a U.S. additional support to the dollar. Conversely, other exchange. But ADRs are still exposed to currency developed market central banks are likely to be more risk. An ADR share tracks a stock in a foreign aggressive and keep their interest rates lower for country—and if that country’s currency is devalued, longer. America’s growing economy, combined with VJGFGXCNWCVKQPYKNNɦNVGTFQYPVQVJG#&4 less sanguine outlooks for other developed and emerging market economies, should result in funds The moral of this story is that when investing ɧQYKPIDCEMKPVQVJG7PKVGF5VCVGUHTQOKPVGTPCVKQPCN INQDCNN[EWTTGPE[ɧWEVWCVKQPUECPRNC[CXGT[ and domestic investors to capitalize on favorable important role in the total return of an investment. fundamentals.

Exhibit B U.S. dollar reaction to Federal Open Market Committee (FOMC) statement

81.6

81.4

81.2

81.0

80.8 2:30 FOMC Chairman Press Conference 80.6

80.4

80.2

U.S. dollar (DXY-NYFE) – June 19, 2013 1-minute intraday

5QWTEG$NQQODGTI(KPCPEG.2&:;KUCOGCUWTGQHVJGXCNWGQHVJG75FQNNCTTGNCVKXGVQCOCLQTKV[QHKVUOQUVUKIPKɦECPVVTCFKPIRCTVPGTU6JKUKPFGZKU similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. Composition: euro 57.6%, Japanese yen 13.6%, British pound 11.9%, Canadian dollar 9.1%, Swedish krona 4.2%, Swiss franc 3.6%.

1 Source: FactSet 2 Source: Bloomberg Finance LP

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The dollar tends to follow long-term cycles lasting The recent rally in the U.S. dollar has been between six and 10 years. The latest clearly concentrated in gains versus developed market KFGPVKɦCDNGVTGPFHQTVJGFQNNCTJCUDGGPC EWTTGPEKGU(TQO,CPWCT[s/C[VJG/5%+'#(' downtrend that began in 2002 and likely ended in U.S. Dollar Hedged Index outperformed the MSCI 2011, as shown in 'ZJKDKV|%. American tourists EAFE Total Return Index by 455 basis points.1 should rejoice, but for investors in non-U.S. equities, a strengthening dollar will cut into returns generated &WTKPIVJGɦTUVSWCTVGTQHVJKU[GCTHWPFUVTCEMKPI by stocks, due to the falling value of the local the MSCI Japan Index without a currency hedge currencies relative to the U.S. dollar. returned 11.7%. Funds with a currency hedge returned over 21.5%.2 *QYECP[QWRTQVGEV[QWTUGNH! When you buy a foreign security, for example a A number of emerging market currencies are also European equity mutual fund, you are investing in not beginning to show weakness against the dollar. only the underlying portfolio of European stocks, you Since May, the South African rand has dropped are also taking a position in the euro. If the euro approximately 9% versus the dollar, while the Indian appreciates relative to the U.S. dollar, that rupee has dropped 5%.1 appreciation enhances the return on your investment. Conversely, a decline in the value of the euro will To help mitigate that risk, institutional investors detract from your return, sometimes substantially. have traditionally employed hedging strategies that involve currency swaps, futures and/or options. More recently, hedged ETFs and mutual funds have been developed to help individual investors potentially protect themselves from adverse currency ɧWEVWCVKQPUYKVJQWVJCXKPIVQGPICIGKPVJGUG types of transactions. Exhibit C 6JG75FQNNCTKUPGCTCNNVKOGNQYU s

The dollar has been in a secular decline for more than a decade. With the average U.S. dollar cycle at about eight years and the U.S. dollar near all-time lows, that tide could shift at any time.

10.8 years 6.3 years 7.5 years 9.4 years 6.1 years 180 +95.57% (+11.11% annually) Terrorist attacks, September 2001 160 End of Bretton Plaza Accord, Woods September 1985 140 Black Wednesday, Lehman collapse, September 1992 September 2008 120 +52.06% (+4.56% annually)

100

80 –32.61% (–4.26% annually) –51.70% (–9.25% annually) 60 –40.09% (–7.91% annually)

1967 1972 1977 1982 1987 1992 1997 2002 2007 2012

Source: Deutsche Bank and Bloomberg Finance LP as of 12/31/12.

1 Source: FactSet 2 Source: Bloomberg Finance LP

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Currency hedging has the potential to lower volatility your risk tolerance and the cost of the strategy versus Over shorter periods of time, hedged equity portfolios VJGRQVGPVKCNDGPGɦVUVQDGFGTKXGF+HQWTUVTGPIVJGPKPI JCXGDGGPUKIPKɦECPVN[NGUUXQNCVKNGVJCPWPJGFIGF dollar scenario holds true, however, the cost and risks equity portfolios, and have avoided the aforementioned of not hedging your non-U.S. investments may be large currency losses. considerably more substantial. Professional advice is recommended, even if you are an experienced global Consider, for example, the international equity investor with a thorough understanding of the indices operated by Morgan Stanley Capital alternatives available to you. Additionally, clients must International (MSCI). The traditional versions of the meet eligibility requirements. MSCI international equity indices are unhedged, meaning investments that seek to track them (such #NGUUEQORNGZDWVGɥGEVKXGYC[VQCXQKFJCXKPIICKPU as exchange-traded funds, or ETFs) have currency risk. in overseas stocks wiped out by adverse moves in the To address currency risk, MSCI recently developed foreign-exchange markets are ETFs and mutual funds currency-hedged versions of their indices, which hedged back into U.S. dollars. This has the potential to employ currency forwards. The goal is to mitigate protect you against adverse movements in the currency the losses associated with currency volatility for a of the country or countries in which you are investing. U.S. investor. Risks of currency hedged investments Since inception on February 10, 2011, the four Currency exchange rates can be very volatile and currency-hedged MSCI indices have shown lower can change quickly and unpredictably and investors volatility than their unhedged counterparts. may lose money.

%WTTGPE[KUXQNCVKNGDWVUGEWNCTVTGPFUOC[DGPGɦV In addition, currency-hedge strategies don’t look as long-term investors good in environments in which the dollar is weakening. For investors considering hedging their portfolios In light of all of these considerations, you should speak using futures or options, these strategies are YKVJ[QWTɦPCPEKCNCFXKUQTVQFGVGTOKPGKHEWTTGPE[ complicated and should be formulated with regard for hedged strategies are right for you. such factors as the composition of your equity portfolio,

Exhibit D Volatility since inception on 2/10/11

26.07%

19.60% 19.95% 19.93% 18.28% 19.26% 15.06% 13.65%

MSCI EAFE IndexMSCI Emerging Markets IndexMSCI Brazil Index MSCI Japan Index

Hedged version Unhedged version

Source: Bloomberg as of 3/31/13. Performance is historical and does not guarantee future results. Hedged indices are represented by the MSCI EAFE U.S. Dollar Hedged Index, MSCI Emerging Markets U.S. Dollar Hedged Index, MSCI Brazil U.S. Dollar Hedged Index and MSCI Japan U.S. Dollar Hedged Index. It KUPQVRQUUKDNGVQKPXGUVFKTGEVN[KPCPKPFGZ%WTTGPVRGTHQTOCPEGOC[FKɥGTHTQOVJGFCVCUJQYP8QNCVKNKV[KUTGRTGUGPVGFD[UVCPFCTFFGXKCVKQPVJGJKIJGT the standard deviation, the greater the volatility.

The sources, opinions and forecasts expressed herein are those of certain business divisions of Deutsche Asset & Wealth Management, are as of August 2013 and any forward-looking statements may not actually come to pass. This information is subject to change at any time based on market and other conditions and should not be construed as investment advice.

Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services.