A reader suggested a clever way to build synthetic EUR-hedged ETFs inside Testfol.io. Now that the platform supports UCITS ETFs, the methodology can finally be tested. The settings are below:
Here the settings:
The one thing to remember is to set the base currency to EUR.
The synthetic volatility is a bit off, but the approach does a decent job given how simple it is. This matters because it lets us test “Sharpe-efficient” portfolios from the perspective of a European investor, and the cornerstone of that analysis is the Golden Butterfly.
The Golden Butterfly is the easiest proxy I know for an investor who cares about returns and volatility at the same time. I have spent many posts on why both matter. The core argument is that it is more efficient, including in terms of YOUR time, to hold one holistic portfolio than to tinker with buckets and assign probabilities to future liabilities. The GB works across a lifetime, from accumulation to decumulation, and it is the best candidate for leverage: first you find the maximum Sortino (yes, I’m writing Sharpe because it’s faster, and you know the limitations by now), then you add leverage on top.
Here is how a European would implement it:
By holding EUR bonds, the European investor gets a better Sharpe ratio. CAGR is lower, which is carry doing exactly what carry does. But nobody holds the GB for raw returns; they hold it for risk-adjusted returns. That is the entire point.
An astute reader will notice both portfolios are rebalanced daily. I need that for a later stage of the analysis, and in any case this is a relative comparison, so rebalancing frequency doesn’t touch the part we care about. In real life the Euro-portfolio would likely show a different, probably better, CAGR. That doesn’t matter, as long as I can reliably rank portfolios within this exercise.
The next step is adding trend following, a subject the blog has covered at length. The cash allocation in the GB exists mostly to hedge certain inflationary scenarios, and we know trend following is the better tool for that job.
You don’t need rolling returns to see how the three portfolios compare, because the chart is already on a log scale. The DBMF portfolio gives up nothing before 2022 relative to the other two, outperforms the blue line in 2022, and keeps that extra performance afterward.
Think of two cars on a circuit, one with brakes and one without. On the straights they perform about the same. The difference shows up at the first turn, and then it compounds turn after turn. Here we have seen only one turn, maybe two, which is not enough to draw firm conclusions, but it gives a fair idea.
Here are the other metrics:
Ever since MFEH was listed in Europe, the question has been: should I currency-hedge DBMF? That is the wrong question. The right one is: how much FX risk should my portfolio carry?
Unfortunately, you don’t have an ISDA agreement, and you can’t call your bank to sell USD against EUR and roll the hedge. You can’t overlay it. You are forced to decide instrument by instrument, and what matters is the cost of hedging, not whether you are hedging stocks, bonds or a flat in DUMBO, NYC.
Consider the options. Buy EUR bonds instead of currency-hedged Treasuries and the hedging cost is zero, but you take on basis risk. Because you now hold debt issued by countries that are not the United States. That might be good or bad. As the world stands today, it ranges from irrelevant to bad. Keep your eyes open (I am assuming at AAA EUR govies here).
Swap USD stocks for EUR-denominated ones and the basis risk becomes enormous. There is a vast difference between Nvidia and STMicro, and an even bigger one between Google and… well, nothing. Apple and… nothing again. Meta and… do I need to continue?
Back to the original question. The hedging cost embedded in MFEH appears cheap (we need more data for a real test), and there is no basis risk. So does MFEH make sense over DBMF for a European optimizing for Sharpe?
The answer looks like yes.
Remember that our synthetic hedge overstates volatility, and we still get a better Sharpe despite that. I don’t think the test is bulletproof, but I would bet it is directionally correct. Everything depends on how well the hedge is executed inside MFEH, but the absence of basis risk is already a point in the strategy’s favor.
If you care more about reducing volatility than maximizing returns, MFEH is a good choice.
link to the test.
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