More to Come for Currency Hedged ETFs

International equity exchange traded funds have been prolific asset gatherers this year and much of that growth has been powered by currency hedged ETFs, but with that growth has come concerns that the strong dollar cycle is long in the tooth.

For currency hedged ETFs, the good news is that flows to these funds prove investors are becoming aware of the advantages of hedging currency risk.

“As the U.S. dollar rises, foreign currencies buy fewer dollars than before. Investors are finding that when their international equity investments are translated back to dollars, returns have been meaningfully diminished due to the effect of currency depreciation,” said Deutsche Asset & Wealth Management head of ETF Strategy Dodd Kittsley in a recent research note. “For example, currency exposure posed a headwind of almost 19 percentage points to the return of the MSCI EAFE Index over the past year. Leaving the index’s currency exposure unhedged meant that a positive return of 17.7% (in local currency terms) was reduced to –0.9% when converted back to U.S. dollars. Investors who did not hedge found themselves in the painful position of choosing the right equity exposure, but having their return swamped out by a different (and perhaps unintended) driver of risk and return.”

Led by the WisdomTree Europe Hedged Equity Fund (NYSEArca: HEDJ) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF), currency hedged ETFs took in the bulk of new ETF assets in the first quarter. Currency hedged ETFs, which hold short positions in foreign currencies, such as the euro and yen, along with baskets of international equities, added $26.8 billion in the first quarter, according to BlackRock. [Dollar ETFs Have More Upside Ahead]

DBEF, a currency hedged play on the popular MSCI EAFE Index, has added $7.84 billion in new assets. To say the ETF’s asset growth has been staggering is to understate the matter. In mid-March, DBEF had $6 billion in assets under management. That number is now over $10 billion. Importantly, DBEF is up 13% compared to 8.4% for the unhedged MSCI EAFE Index. [Stunning Growth for This Currency Hedged ETF]

Predictably, the breakneck asset growth pace by ETFs like DBEF and the Deutsche X-Trackers MSCI Europe Hedged Equity ETF (NYSEArca: DBEU) has investors pondering just how long the current dollar bull market lasts. Kittsley sees the dollar bull market as still in the early innings.

“That said, a common question among investors is how long this trend can last. Given the pace and mag-nitude of the move in the U.S. dollar in recent months, many fear they have missed the cycle, and moving into a currency-hedged investment now may be too late. But based on the ongoing divergence in economic growth and central-bank policy between the United States and most of the world, we believe the U.S. dollar will continue to strengthen over the coming years,” he said.

Those divergences in monetary policy are compelling investors to take a more tactical approach to currency hedged ETFs, which includes increased use of single-country funds.