Exchange-traded products have permanently changed the investment industry by giving advisors and their clients access to an ever-evolving range of exposures and strategies that were previously only available to institutional pools of capital.
This has been especially true with how foreign investments are utilized. Ten years ago, ETF selection was limited to funds tracking broad indexes like the MSCI EAFE Index and a handful of single country funds, as no individual ETF yet existed that invested in foreign bonds or currencies.
A broadening array of equity funds eventually provided access to relatively smaller countries. Specialty equity funds brought exposures to narrower foreign sectors, themes and niches in both developed and developing markets. This was soon followed by foreign fixed income funds and then currency ETFs.
As these new funds began to proliferate in the last decade, advisors and their clients aggressively sought their application because the U.S. dollar was generally going down against many other currencies. This had the effect of boosting returns for U.S. investors.
Just as investment products have evolved, so too have markets. Lately, the U.S. dollar has gone up against many currencies contributing to the general underperformance of developed and emerging markets.
The ensuing currency drag led to the wave of innovation that is currency hedged equity funds. There are at least 20 equity ETFs that hedge or neutralize the currency exposure, and these funds have quickly gained mass. The largest fund in the niche contains more than $12 billion in assets.
The performance difference when hedging out the currency can be meaningful. In 2013, the WisdomTree Japan Hedged Equity Index was up 54% versus just 27% for the MSCI Japan Index. Most of that difference is attributable to the yen's unexpected 20% decline, which is huge by currency standards.
Currency hedging will play a role in other assets as well. Many emerging market bonds are issued in dollars, which obviously removes currency from the equation while offering higher yields than many segments of the domestic bond market. However, an investor seeking higher yields from developed markets such as Australia or New Zealand still takes currency risk. A recent look at the Australian five-year note showed a yield of 3.5% versus just 1.5% for a similar U.S. Treasury note, but in the last year the Aussie dollar fell 13% against the greenback, which obviously more than offset the pick-up in yield.
These are conversations that 10 years ago no advisor would have had with colleagues or with clients. Now clients are learning about these strategies and want to know whether they are suitable for their portfolios. Advisors need to be prepared to have these discussions and be ready to educate clients on how involved they should or should not get with currency exposures.
The current course seems to indicate that advisors will gravitate toward sterilizing the currency effect from the equity and fixed income holdings and will seek out specialized currency-related products. By doing so, it allows advisors to more easily manage the exposure with one or two products without needing to overhaul clients’ entire portfolios, which is preferable for tax reasons and to reduce commission drag.
These kinds of currency products are starting to hit the market but still remain in the early days of their development.
The space will continue to evolve because increasingly more knowledgeable investors will demand it, and it will be in the ETF providers’ interests to meet that demand. It will be incumbent on advisors to keep up with how the industry evolves in this direction not only for their clients’ well-being, but also to ensure practice sustainability.