It cannot be put anymore simply than this: The U.S. dollar is strengthening while a raft of developed market currencies are weakening.
With the end of quantitative easing near and some traders overtly pricing in higher U.S. interest rates in the months ahead, the dollar is in style. Combine that with accommodative monetary policies from the Bank of Japan, European Central and Reserve Bank of Australia, and it can be said a perfect storm is brewing for currency hedged ETFs.
Although some currency hedged ETFs have been around for several years, last year represented the true emergence for the group when the WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) and theDeutsche X-trackers MSCI Japan Hedged Equity ETF (NYSEArca: DBJP) posted an average gain of almost 42% compared to a 26% gain for the unhedged iShares MSCI Japan ETF (NYSEArca: EWJ). [Currency Hedged ETFs: Lessons From Japan]
Still, currency hedged ETFs remain “underutilized risk-management and portfolio-building tools,” in the eyes of Deutsche Asset & Wealth Management. Naysayers could argue the ETF arm of German banking giant Deutsche Bank (NYSE: DB) is merely talking its book as one of the largest issuers of currency hedged ETFs. However, the criticism is short-sighted and ignores compelling data.
“For U.S. investors, currency returns have largely enhanced the performance of unhedged international equity investments over the past decade. This will not remain the case indefinitely. As unhedged investors have found in recent years, a declining U.S. dollar will positively contribute to the returns of unhedged foreign-market investments—but a soaring U.S. dollar will do the opposite, detracting from returns. Currency movements present an element of uncertainty for U.S. investors holding mutual funds and ETFs that invest in international equities,” according to new research from DAWM.
Consider this prime example of the inflated benefits of the previously weak U.S. dollar: From 2000 through 2013, the MSCI EAFE Index gained 45%, but when stripping out the effect of the weak dollar, the index was essentially flat said Luke Oliver, Head of Capital Markets for Passive Investments at Deutsche Asset & Wealth Management, in an interview with ETF Trends from the Morningstar ETF Conference in Chicago. [Loving Currency Hedged ETFs as the Dollar Rises]
That serves as an important reminder that currency hedged ETFs off opportunity well beyond Japan. With monetary policies appearing loose throughout much of the ex-U.S. developed world, the iShares MSCI EAFE ETF (NYSEArc: EFA) is off about 1.2% this year. However, EFA’s hedged rival, the DeutscheX-trackers MSCI EAFE Hedged Equity Fund (NYSEArca: DBEF) has gained 3%.