International small-cap stocks and the related exchange traded funds are easily outperforming the Russell 2000 Index and the S&P SmallCap 600 Index this year. Many of these international smal-cap funds are not currency hedged, many they are positively correlated to stronger local currencies.
However, the U.S. dollar has recently shown signs of life, a scenario that could open the door to opportunities with ETFs such as the Deutsche X-trackers MSCI EAFE Small Cap Hedged Equity ETF (BATS: DBES). As its name implies, the Deutsche X-trackers MSCI EAFE Small Cap Hedged Equity ETF is a currency hedged ETF, but the lethargic dollar has not been a drag on this fund. DBES is up 25% year-to-date, putting it well ahead of competing domestic small-cap strategies.
Many have looked into international markets during a prolonged U.S. rally that stretched valuations at home. With the U.S. dollar beginning to strengthen against its peers, investors should reconsider currency hedged ETFs to limit potential foreign exchange risks.
DBES “seeks investment results that correspond generally to the performance, before fees and expenses, of the MSCI EAFE Small Cap U.S. Dollar Hedged Index. DBES offers investors purer access to small-cap developed market equities while mitigating exposure to fluctuations between the value of the U.S. dollar and select foreign currencies,” according to Deutsche Asset Management.
The U.S. dollar is strengthening on a number of factors. For instance, the U.S. index of business conditions rose to a three-year high, adding to the improving U.S. economic outlook. Furthermore, Federal Reserve Chair Janet Yellen reaffirmed the central bank’s commitment to hiking rates, despite disappointing inflation results.
Importantly, DBES is heavily allocated to markets that are viewed as having compelling valuations relative to the U.S. For example, Japan accounts for over 30% of the ETF’s weight while DBES also features significant exposure to rebounding Eurozone economies.
Related: International Small-Cap ETFs Deliver Stellar Returns
DBES is conservatively positioned at the geographic level and in the ETF’s just over two years on the market, its volatility traits compare favorably with those found on U.S. small-cap benchmarks.
With earnings growth improving in ex-US developed markets, the time could be right for investors to favor cyclical sectors. DBES obliges on that front with an almost 23% weight to industrial stocks. Cyclical consumer discretionary and technology names combined for almost 28% of the ETF’s roster.
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