As 2014 draws to a close, so-called currency hedged exchange-traded funds have been gathering assets. These U.S. ETFs invest in overseas equity markets while adding a hedge that neutralizes the impact of converting stock market gains from a weaker currency like the yen or the euro to a stronger U.S. dollar.
While the U.S. was the leading proponent of quantitative easing and its dollar was relatively weak, that conversion was a bonus. Between 2000 and 2010, when the greenback lost 40 percent of its value, U.S. investors that made unhedged allocations to the MSCI EAFE basket of non-U.S. developed-markets stocks gained 45 percent through currency exposure, even though “the equities returned zero,” Luke Oliver, New York–based head of capital markets at Deutsche Bank’s Asset & Wealth Management division, said in a recent webcast.
But since May, when the dollar started to strengthen against the euro, unhedged investors in MSCI EAFE “would have given up 10.5 percent,” Oliver added. In a subsequent interview he noted that the bank’s currency hedged EAFE fund, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF), had grown from $257 million in assets at the start of 2014 to $1.4 billion in December in response to that trend.
Year-to-date through November 30, DBEF had a 6.94 percent gain in net asset value, whereas the unhedged version of the MSCI EAFE index was down 1.49 percent, according to the Deutsche Bank web site.
The shift toward a strengthening dollar became more pronounced with the U.S. Federal Reserve Board’s October announcement that it would stop buying government bonds, followed by the news that the Bank of Japan was moving in the opposite direction with another big blast of QE. By December speculation was growing to near certainty that the European Central Bank would have to engage in further easing next year.
The balance began to tilt in favor of the dollar in April 2013, when the BoJ launched its massive bond-buying program. QE is deliberately inflationary and tends to boost a country’s stock market, but it can also be hell on that nation’s currency.
By the end of 2013, the value of hedging an investment in Japanese stocks had become evident, says Dodd Kittsley, New York–based head of ETF strategy at Deutsche Asset & Wealth Management, which sponsors 12 currency hedged products in the U.S. market with a combined $11.7 billion in assets as of November 28.
In 2013 the MSCI Japan index was up 54.58 percent for the year, but U.S. investors lost about half of that gain to currency conversion, Kittsley says. The dollar-denominated unhedged version of that index was up just 27.16 percent, he notes.
As for 2014, “Performance was very definitely in favor of the hedged products for most of this year,” says Joseph Nelesen, San Francisco–based head of the institutional product management and consulting team at iShares, the ETF arm of U.S. asset manager BlackRock.
The contrast between hedged and unhedged ETFs is the most striking with iShares because it has directly comparable funds. Last January the firm began offering currency hedged versions of three of its well-established international equity ETFs: the $15.4 billion iShares MSCI Japan ETF (EWJ) and the $4.7 billion iShares MSCI Germany ETF (EWG), which launched in 1996, and the $52.9 billion iShares MSCI EAFE ETF (EFA), which began trading in 2001. The new, hedged versions — HEWJ, HEWG, and HEFA — buy shares in their parent ETFs and add a hedge via currency forwards so investors can “switch into the hedged version without changing the underlying exposure,” Nelesen says.
Year-to-date as of November 30, the unhedged versions all had total return losses: EWJ fell 2.99 percent, EWG lost 6.31 percent, and EFA dropped 1.62 percent.
From the January 31 launch of the hedged versions through November 30, HEWJ posted a total return gain of 19.84 percent, HEWG gained 7.09 percent, and HEFA climbed 11.69 percent. Those ETFs are still much smaller than their parents: Collectively they managed about $465 million as of December 12. But most of the inflows have been in the fourth quarter, Nelesen observes. From September 30 onward, the three hedged ETFs gained a total of $344.5 million, with HEWJ adding $181 million in the first week of November, after the BoJ’s surprise announcement.
(iShares has since added two other currency hedged equity ETFs; combined assets were $491.4 million as of December 15.)
Nelesen points out that “over the long term in developed markets, historically, currency risk evens out”; therefore, “buying and holding the unhedged products makes a lot of sense.” But the recent experience does “illustrate how impactful currency weakening can be on an international equity portfolio,” he adds.
Scott Kubie, chief investment strategist at CLS Investments, an Omaha, Nebraska–based money manager and ETF strategist firm with $6.5 billion in assets, says he’s been hedging some of his exposure to Japan since 2013 with several of the hedged ETFs, and he started doing the same with Europe last June.
Kubie’s internationally focused regional rotation strategy is now 25 percent hedged versus its unhedged benchmark, the MSCI ACWI ex USA Investable Market index. “Europe and Japan represent the two best opportunities for hedging now,” he says. That percentage is “likely to climb in the future” if the BoJ and the ECB “behave as expected,” Kubie predicts. But he also points out that “there have been many years where hedging hurt as well.”
Michael Jones is chairman and CIO of RiverFront Investment Group, a $4.95 billion asset manager and ETF strategist firm based in Richmond, Virginia. About 18 percent of the international assets in RiverFront’s $2 billion flagship product — its moderate growth and income strategy, which was up 7 percent year-to-date as of November 30 — is now hedged, he says.
Jones’s biggest positions are in the two largest currency hedged ETFs from WisdomTree Investments: the $12.8 billion WisdomTree Japan Hedged Equity ETF (DXJ) and the $5 billion WisdomTree Europe Hedged Equity ETF (HEDJ).
WisdomTree has 12 ETFs in its currency hedged equity family with a total of $17.8 billion in assets as of December 15. The New York–based firm creates its own indexes, and its hedged currency products track dividend-paying companies that get most of their revenue from exports outside the euro zone or Japan, explains director of research Jeremy Schwartz.
“The concept of weighting equities by export orientation really resonated with people,” Jones says. “The strategy makes a lot of sense, because if you’re worried about domestic growth in Japan or the euro zone, the companies that export a lot are the least vulnerable.”
One country to watch in 2015 is South Korea. With all of the moves by the Japanese to weaken the yen, the Asian nation might start devaluing its currency, the won, to stay competitive with Japan on exports. South Korea is “getting antsy; there’s more rhetoric out of its central bank,” Schwartz says.
WisdomTree and Deutsche have South Korea currency hedged ETFs, but they’re still small: The WisdomTree Korea Hedged Equity Fund (DXKW) manages just $11.2 million, whereas the Deutsche X-trackers MSCI South Korea Hedged Equity ETF (DBKO) has $4.6 million in assets. That may soon change. The verdict from Deutsche’s Oliver: “We definitely think that South Korea is an interesting story.”
