ETFs: Is Window For Currency Hedge Closed?

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L ast year the ETF industry launched 10 currency-hedged exchanged traded funds, doubling the total number available, in time to maximize their potential against the falling yen and the euro. But some are now beginning to wonder if the strategy these ETFs follow has hit its sell-by date and the currency hedge is no longer needed.

"When the euro cost $1.40, no one believed that Europe would do a quantitative easing," said Brent Schutte, senior investment strategist at Chicago's BMO Global Asset Management, which has $271 billion under management. "But now those central bank policies are baked into the value. In order for these currencies to fall more, the divergence has to be bigger than what the market currently expects."

Starting in May 2014, the euro and the yen plunged in value against the dollar. The euro has sunk to about $1.06; the yen has slipped to $.0084 from about $0.01.

The dollar's strength came from a combination of the Federal Reserve Bank's ending its quantitative easing program due to a stronger economy, and anticipation that U.S. interest rates would soon rise.

Then in October, the Bank of Japan increased the quantitative easing program that it had started in 2013. In January 2015, the European Central Bank began its own quantitative easing and rate cuts.

For U.S. investors with international exposure, currency-hedged ETFs came just in time. As these equity markets began rising, their currencies began falling. In addition to holding equities from a region or sector, these ETFs use monthly forward contracts to take currency exposure out of the mix.

These ETFs don't get hurt when the currency falls, nor do they benefit when the currency rises. The return that they receive comes only from the local stocks' movement.

Investors piled in. Of the $59.1 billion net inflow into the entire universe of ETFs, $22.6 billion, or 38%, flowed into just the 20 currency-hedged ETFs, according to Morningstar Inc.

"The money you see pouring into these funds is money chasing near-term performance," said Ben Johnson, Morningstar's director of ETF research, "and not a reflection of investors having an 'Aha' moment pertaining to how they maintain their currency exposure in an equity portfolio."

The two largest currency-hedged ETFs areWisdomTree Europe Hedged Equity ETF ( HEDJ ), with $17.3 billion in assets, and $15.8 billionWisdomTree Japan Hedged Equity ETF ( DXJ ). In the past year, HEDJ rose 28% vs. the 3.5% return of the MSCI EAFE index. DXJ gained 38%. They're up 23% and 15%, respectively, this year.

Time To Get Out?

Schutte says it's time to get out of currency-hedged ETFs and buy unhedged funds such as SPDR Euro Stoxx 50ETF ( FEZ ) and iSharesMSCI Japan ETF ( EWJ ). SPDR Euro Stoxx fell 3.8% last year but is up 7.4% this year. MSCI Japan rose 20% last year and is up 15% this year.

But WisdomTree research director Jeremy Schwartz counters that investors are still getting paid a small amount to hedge the currencies. "You will get paid 1% to 2% to hedge the euro as the Fed raises its rates over the next two years, as long as the ECB keeps its rates low. The relative differential between the two central banks will relate to how much you get paid."

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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