Currency Hedged ETF Craze Just Starting

With the asset-gathering prowess displayed by the Deutsche X-trackers MSCI Japan Hedged Equity ETF (NYSEArca: DBJP) and the WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) after Prime Minister Shinzo Abe came to power and similar dominance being shown this year by the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF) and the WisdomTree Europe Hedged Equity Fund (NYSEArca: HEDJ), some investors might be inclined to think the currency hedged ETF craze is getting long in the tooth.

With the U.S. dollar crushing rival developed market currencies, the currency hedged ETF movement looks like it is still in the early innings. That even after investors have poured over $12 billion into the ETFs that strip out foreign currency risk while capitalizing on dollar strength.

Assets in currency hedged ETFs have swelled by $36 billion over the past three years and, importantly, 90% of the $12 billion that has gone into the funds this year has flowed to products that are not dedicated Japan ETFs, according to a new research piece by Deutsche Asset & Wealth Management head of ETF Strategy Dodd Kittsley.

Year-to-date, HEDJ and DBEF have combined to add over $10.5 billion in new assets, making the pair the top two asset-gathering ETFs. Only four ETFs, including HEDJ and DBEF, have added more new assets than DXJ.

“Many international equity exchange-traded funds (ETFs) posted negative return in 2014 despite the positive performance of the equities they held. How could this be? The answer: currency exposure. In 2014 the MSCI EAFE Index returned 5.9% in local currency terms but –4.9% in U.S. dollar terms, a difference of 10.8 percentage points,” said Kittsley.

The currency hedged advantage is continuing in 2015. Importantly, currency hedged ETFs are showing advisors and investors the advantages of muting currency risk in a strong dollar environment. For example, DBEF is up 8.5% this year, better than triple the gain of the iShares MSCI EAFE ETF (NYSEArca: EFA). The Deutsche X-Trackers MSCI Europe Hedged Equity ETF (NYSEArca: DBEU) has smoked the unhedged Vanguard FTSE Europe ETF (NYSEArca: VGK) to the tune of a five-to-one advantage. [A Rush to Europe ETFs]

“Quite simply, investors have taken notice of the broad-based appreciation of the U.S. dollar relative to other developed-market currencies that has occurred over the past several months. The relative strength of the U.S. economy has led to monetary policy divergence,” notes Kittsley.

Said another way, the Federal Reserve ended quantitative easing last year, but the Bank of Japan is highly unlikely to follow suit while the European Central Bank has unveiled its QE regime. Other developed market central banks, including the Reserve Bank of Australia, are cutting rates.