Just when it was looking safe to wade back into the waters of emerging markets exchange traded funds, investors got a cold reminder regarding the damage a strong U.S. dollar and rising interest rates can do to developing world stocks.
Over the past month, the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) and the iShares MSCI Emerging Markets ETF (NYSEArca: EEM), the two largest emerging markets ETF by assets, are off an average of 5%. Perhaps not coincidentally, the PowerShares DB U.S. Dollar Index Bullish Fund (NYSEArca: UUP), which tracks the price movement of the U.S. dollar against a basket of currencies, including the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc, is slightly higher while 10-year Treasury yields are up 4.7%. [Recent Weakness in Dollar ETFs Only a Minor Setback]
Obviously, one way of coping with the latest downdraft in emerging markets stocks is shorting EEM, but BNP Paribas suggests taking things a step further and pairing a short position in EEM with a long trade in the WisdomTree Europe Hedged Equity Fund (NYSEArca: HEDJ), reports Chris Dieterich for Barron’s.
In a note posted by Barron’s, BNP Paribas reminds investors that rising U.S. interest rates and the strong greenback will likely crimp emerging markets equities.
“Capital flows that are seeking safe growth or looking for a cash yield in a reserve currency no longer flow into EM. The embedded dollar exposure of EM corporates listed on a USD-denominated instrument is a natural detractor from performance,” according to BNP Paribas by way of Barron’s.
For its part, HEDJ has been a major beneficiary of the strong dollar. Although the ETF is down 4.1% over the past month, it is still up nearly 13% year-to-date, a performance that is 600 basis points better than one of its largest unhedged rivals. Not to mention, investors have poured $13.7 billion into HEDJ this year, $3.6 billion more than the second-best asset gathering ETF.