If you have been following the ETF industry at even a cursory level, it’s been difficult to miss the fervor surrounding currency-hedged funds. This dynamic strategy first burst onto the scene with the release of the WisdomTree Japan Hedged Equity Fund (DXJ) in 2006. DXJ quickly amassed an impressive track record as its dual threat of equity and currency exposure propelled it into the spotlight. Assets soon followed and the fund has since grown to $9.1 billion in size.
This success was then shadowed by a slew of successive international indexes trying to capitalize on the currency hedged theme. There now exists nearly 100 ways to play this space that include: broad baskets, regional indexes, single countries, and more. Here is a complete list of all the active currency-hedged ETFs available today via ETF.com.
The thesis behind this strategy was born out of unprecedented central bank intervention and global stimulus, which helped fuel the desire for greater control over currency exposure. Furthermore, successive year-over-year comparative gains versus unhedged international funds continued to strengthen the case for investing with a currency hedged bias.
Then something interesting happened in the early part of 2015. The U.S. dollar stopped moving higher and instead we saw a swinging of the pendulum in the opposite direction. The 2-year chart below of the PowerShares U.S. Dollar Bullish Index (UUP) shows this effect in stark detail.
The U.S. dollar has not only been slowly losing ground versus its largest peers such as the euro and yen, but also some important outlier countries as well. The following table highlights the appreciation in global currencies versus the U.S. dollar on a year-to-date basis through April 29, 2016. This data is courtesy of Charlie Bilello, Director of Research at Pension Partners.
Put simply, the increase in value of these currencies versus the U.S. dollar has acted as an invisible tailwind for traditional ETFs that lack a currency component. One prime example is the iShares MSCI Brazil Capped ETF (EWZ), which has rallied an impressive 40% this year. When overlaid versus the Deutsche X-trackers MSCI Brazil Hedged Equity ETF (DBBR), it’s easy to see what is driving the current performance gap.
While the effect is most prominent in single countries that have experienced a significant currency movement, there is also gathering momentum in broader unhedged indexes as well. The iShares MSCI EAFE ETF (EFA) is currently running at a 4.60% performance edge versus the iShares Currency Hedged MSCI EAFE ETF (HEFA) so far this year. Continued weakness in the U.S. dollar index will only serve to widen that gap if the current trend remains intact.
The Bottom Line
The proliferation of innovative ETF strategies such as currency hedging has given investors greater control over their international stock exposure. This can be both a blessing or a curse depending on how the currency markets react to the changing economic landscape.
While currency hedged ETFs quickly grew in size and popularity due to cyclical trends, it’s also important to remember how those factors can play an opposing role as well. There will be periods of time where hedged and unhedged ETFs offer stronger returns. It’s up to you to be diligent about how you construct your allocation to international stocks and avoid chasing performance at the tail end of a new cycle to achieve the best results.