Currency Hedging

So I bought the Wisdown Tree Hedged Japan ETF after Abe was elected about a year ago. Now that the general rally is over (I believe) I’d like to buy a couple of stocks I believe are set to outperform, but I’m not sure how to hedge the currency in my PA. I haven’t reviewed this stuff since my CFA days.

Is it possible to currency hedge a relatively small JPY position to USD? What about if I want to hedge a more volatile currency, the Rupiah for instance? This is in a personal account and the investment amound is in thousands, so would costs be exorbitant?

Who is your broker? I’m guessing this will be difficult in a retail account but I’ve never tried to hedge my PA before.

My experience with hedging foreign-currency denominated stocks is limited but I did look into this a few years ago with Japanese stocks in an institutional account. The firm I used to work at primes with GS and they recommended short duration forwards to create a rolling hedge, which is a very inexpensive method. I don’t know if that’s the best approach. The difficulty is the asset values of the underlying move, so the hedge needs to be short-term if you want to minimize basis risk.

Why Japan?

It’s really a defensive hedge. The combination of continuing easy money in Japan and Fed tapering sometime next year could reinvigorate the USD/JPY rise. It’s been a big move over the last year, but took a bit of a pause in May. For a lot of US domiciled investors in Japan over the last year, currency depreciation eroded half their return. I’m seeking to avoid the second act of that. I also think the general rally in Japan may be long in the tooth, and now it is time to take the rifle off the shelf and put away the shotgun; thus, I’m looking at hedging specific stock positions.

The Abe government creates some interesting dynamics for some Japanese stocks and the monetary regime is relatively clear in its direction now, much different from what’s happening in the US. Additionally, many Japanese companies are not particularly friendly to foreign investors, so there is some information asymmetry and the space is generally unloved by very large asset managers.

You can say that again.

Seems like there are two main ways to play this:

  1. Buy net-net small caps (or other good inefficiently priced small caps) and hope the market rerates these above cash value / liquidation value.

  2. Buy institutional names (blue chips) that have secular tailwinds and benefit from an overall rising tide in Japan.

#1 has better return potential if you think a rerating will actually happening. #2 is safer and more likely IMO.

I met about 50 companies when I was in Japan and spoke to another 50 or so on the phone. I looked at a few hundred stocks overall. There is INCREDIBLE (!!!) value destruction and incompetence in the small cap arena. Additionally, there is no market for corporate control, so you can’t expect a buyout or activist effort, even in quality assets (ask Steel Partners).

Small and microcaps in general are a swamp in the US (lots of fraud, adverse selection bias, misleading management teams, etc.). In Japan there is less fraud but 20x more incompetence. If you want to play #1, I’d recommend just buying an ETF that tracks Japan small caps and be done with it. I never look at blue chip stocks in any market, but probably you could find at least a few with relative ease in Japan that have nice secular tailwinds and just buy and hold those.

If you know the JPY delta of your portfolio, you can easily hedge the currency risk using a retail FX broker account. Transaction costs for JPY will be very low, even for retail accounts. I’m not familiar with the specific details of that ETF, but if it’s just like investing in Japanese stocks in JPY, you can hedge the currency risk by going short the $ amount of your portfolio. You will have to adjust the hedge as the value of the stocks changes.

For a non-tradable currency like IDR, your choices will be limited. Institutional investors can trade NDFs to hedge IDR risk, but as a retail investor, you might just have to carry the risk. The same would apply for other non-deliverable currencies, which unfortunately tend to be the most volatile, like BRL, INR, ARS, etc.

Thanks for the responses. Ohai, the ETF I am referencing is already hedged to USD, so it returns will be in JPY terms (i.e. higher than they would be otherwise). What I was thinking was how to hedge specific stock positions with JPY exposure. If what you said about transaction costs is true for JPY then that is great.

Outside of JPY, I’d expect IDR and INR to be expensive to hedge now because of the big shock over the summer. When the Fed starts talking about tapering again, could likely see a hit to these currencies. What kind of costs to you see for hedging these for an institutional investor trading NDFs? Just curious.

On my screen, I see IDR bid offer spread of about 15 basis point (not pips) for 1 week settlement. INR is more liquid with less than one bp spread. So, if you are a flow desk, you have access to this market. There is no spot market that we can easily access for these two currencies. I suspect most client investors will pay a bit more to the dealer on something like INR, as the clients are likely not sensitive to such small spreads.

Re: your original question, I guess you are asking if JPY changes by x%, what is the correlation with the actual stock price and how do you hedge this? Unfortunately, I don’t have much to add there, other than to look at historical data and multiply the stock position by the JPY return correlation.

Nitpicky point, ohai, but that would be multiplying by covariance, wouldn’t it?