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%.
Currency hedged ETFs are not perfect. No issuer has made that claim and there have been examples of some of these trailing their unhedged peers. That was seen earlier this when the British pound was strong while a stubbornly strong Korean won, at least until recently, has crimped the WisdomTree Korea Hedged Equity Fund (NasdaqGM: DXKW) and the Deutsche X-trackers MSCI South Korea Hedged Equity Fund (NSYEArca: DBKO). [Strong Won a Problem for Some South Korea ETFs]
“Investors with a view of the U.S. dollar relative to foreign currencies should ensure that their foreign market investments reflect their currency outlooks, either by being hedged or unhedged as the case may be. On a total return basis, currency-hedged investments should outperform corresponding unhedged investments during periods when the U.S. dollar is strong. Conversely, when the U.S. dollar weakens, currency-hedged investments generally underperform,” according to DAWM research.
Often overlooked in the discussion about the effect currency fluctuations have on a portfolio’s returns is the volatility those currency gyrations subject investors to. Currency hedged ETFs help ameliorate that situation as well.
Over the 10 years ending in the second quarter of 2014, the hedged equivalents of the MSCI EAFE, MSCI Germany, MSCI Emerging Markets and MSCI All-County World indices were less volatile than their unhedged counterparts, according to DAWM data. Adding the MSCI’s hedged Japan index to that group, all five had higher rolling one-year Sharpe ratios than the unhedged indices for the 10 years ending June 30, 2014.
Table Courtesy: Deutsche Asset & Wealth Management
Tom Lydon’s clients own shares of EFA.