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.

There was a time, not so long ago, when a majority of American investors invested solely in U.S. securities. Today, U.S. investors are allocating an increasing slice of their asset allocation pie to both developed international and emerging market equities.

In Canada, however, rising commodity prices buoyed both that country’s economy and stock market. The S&P/TSX Composite Index rose approximately 23.1%, including dividends. In addition, the Canadian dollar appreciated 17% versus its U.S. counterpart2, thereby giving U.S. investors fortunate enough to have participated in the Canadian index a super charged return. In fact, the S&P/TSX Canadian Index in U.S. dollar terms actually gained 44.65%2, or 4.2% annualized.

Exhibit A Contribution to MSCI EAFE Index return from currency (1983-2012) 30%

2QVGPVKCNTGVWTPKORCEV5KPEGCUKIPKɦECPVRQTVKQPQHKPVGTPCVKQPCNGSWKV[ return has come from currency moves, which can be positive or negative.

25% 20% 15% 10% 5% 0% –5% –10% –15% –20% 1983

1985

1987

1989

Positive contribution from currency

1991

1993

1995

1997

1999

2001

2003

Negative contribution from currency

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

4

2005

2007

2009

2011

Investment spotlight

As a further illustration, consider the reverse of this transaction. Canadian investors participating in the S&P 500 lost not only the 30.3% by which that index declined, but 17% because of unfavorable currency ɧWEVWCVKQPUHQTCVQVCNTGVWTPQH1 or -5.6% on an annualized basis2. Some investors use American Depository Receipts (ADR) to gain exposure to international stocks. However, it is important to note that ADRs are not hedged vehicles. Many investors believe currency risk can be avoided or mitigated through the use of #&4UYJKEJCTG75FQNNCTFGPQOKPCVGFEGTVKɦECVGU KUUWGFD[75DCPMUTGRTGUGPVKPICURGEKɦGF number of shares in a foreign stock traded on a U.S. exchange. But ADRs are still exposed to currency risk. An ADR share tracks a stock in a foreign country—and if that country’s currency is devalued, VJGFGXCNWCVKQPYKNNɦNVGTFQYPVQVJG#&4 The moral of this story is that when investing INQDCNN[EWTTGPE[ɧWEVWCVKQPUECPRNC[CXGT[ important role in the total return of an investment.

The tide may be turning The United States is showing signs of an ongoing economic recovery, and, in our opinion, the United States has better fundamentals than its developed market counterparts. Our forecast for GDP growth next year is 3.2% versus 1.0% for the Eurozone and 0.6% for Japan. The housing sector recovery, a stronger U.S. consumer due to deleveraging, a slowly improving labor market and nascent signs of a pick up in capital spending all support this view. The U.S. Federal Reserve Board’s recent decision to likely slow its monetary purchases of government bonds and mortgage-backed securities adds additional support to the dollar. Conversely, other developed market central banks are likely to be more aggressive and keep their interest rates lower for longer. America’s growing economy, combined with less sanguine outlooks for other developed and emerging market economies, should result in funds ɧQYKPIDCEMKPVQVJG7PKVGF5VCVGUHTQOKPVGTPCVKQPCN and domestic investors to capitalize on favorable 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 2

Source: FactSet Source: Bloomberg Finance LP

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Investment spotlight

The dollar tends to follow long-term cycles lasting between six and 10 years. The latest clearly KFGPVKɦCDNGVTGPFHQTVJGFQNNCTJCUDGGPC downtrend that began in 2002 and likely ended in 2011, as shown in 'ZJKDKV|%. American tourists should rejoice, but for investors in non-U.S. equities, a strengthening dollar will cut into returns generated by stocks, due to the falling value of the local currencies relative to the U.S. dollar.

The recent rally in the U.S. dollar has been concentrated in gains versus developed market EWTTGPEKGU(TQO,CPWCT[s/C[VJG/5%+'#(' U.S. Dollar Hedged Index outperformed the MSCI EAFE Total Return Index by 455 basis points.1 &WTKPIVJGɦTUVSWCTVGTQHVJKU[GCTHWPFUVTCEMKPI the MSCI Japan Index without a currency hedge 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 European equity mutual fund, you are investing in not only the underlying portfolio of European stocks, you are also taking a position in the euro. If the euro appreciates relative to the U.S. dollar, that appreciation enhances the return on your investment. Conversely, a decline in the value of the euro will detract from your return, sometimes substantially.

A number of emerging market currencies are also beginning to show weakness against the dollar. Since May, the South African rand has dropped approximately 9% versus the dollar, while the Indian rupee has dropped 5%.1 To help mitigate that risk, institutional investors 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

180

6.3 years

7.5 years

9.4 years

+95.57% (+11.11% annually) 160

End of Bretton Woods

Plaza Accord, September 1985 Black Wednesday, September 1992

140 120

6.1 years Terrorist attacks, September 2001

+52.06% (+4.56% annually)

Lehman collapse, September 2008

100 80 –32.61% (–4.26% annually)

–51.70% (–9.25% annually)

60 1967

1972

1977

1982

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

1 2

6

Source: FactSet Source: Bloomberg Finance LP

1987

1992

–40.09% (–7.91% annually) 1997

2002

2007

2012

Investment spotlight

Currency hedging has the potential to lower volatility Over shorter periods of time, hedged equity portfolios JCXGDGGPUKIPKɦECPVN[NGUUXQNCVKNGVJCPWPJGFIGF equity portfolios, and have avoided the aforementioned large currency losses. Consider, for example, the international equity indices operated by Morgan Stanley Capital International (MSCI). The traditional versions of the MSCI international equity indices are unhedged, meaning investments that seek to track them (such as exchange-traded funds, or ETFs) have currency risk. To address currency risk, MSCI recently developed currency-hedged versions of their indices, which employ currency forwards. The goal is to mitigate the losses associated with currency volatility for a U.S. investor. Since inception on February 10, 2011, the four currency-hedged MSCI indices have shown lower volatility than their unhedged counterparts. %WTTGPE[KUXQNCVKNGDWVUGEWNCTVTGPFUOC[DGPGɦV long-term investors For investors considering hedging their portfolios using futures or options, these strategies are complicated and should be formulated with regard for such factors as the composition of your equity portfolio,

your risk tolerance and the cost of the strategy versus VJGRQVGPVKCNDGPGɦVUVQDGFGTKXGF+HQWTUVTGPIVJGPKPI dollar scenario holds true, however, the cost and risks of not hedging your non-U.S. investments may be considerably more substantial. Professional advice is recommended, even if you are an experienced global investor with a thorough understanding of the alternatives available to you. Additionally, clients must meet eligibility requirements. #NGUUEQORNGZDWVGɥGEVKXGYC[VQCXQKFJCXKPIICKPU in overseas stocks wiped out by adverse moves in the foreign-exchange markets are ETFs and mutual funds hedged back into U.S. dollars. This has the potential to protect you against adverse movements in the currency of the country or countries in which you are investing. Risks of currency hedged investments Currency exchange rates can be very volatile and can change quickly and unpredictably and investors may lose money. In addition, currency-hedge strategies don’t look as good in environments in which the dollar is weakening. In light of all of these considerations, you should speak YKVJ[QWTɦPCPEKCNCFXKUQTVQFGVGTOKPGKHEWTTGPE[ hedged strategies are right for you.

Exhibit D Volatility since inception on 2/10/11

26.07% 19.60%

18.28%

15.06%

19.95%

19.93%

13.65%

MSCI EAFE Index Hedged version

19.26%

MSCI Emerging Markets Index

MSCI Brazil Index

MSCI Japan Index

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.

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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. © 2013 Deutsche Asset & Wealth Management. All rights reserved. I-32517-1 (9/13)