Innovation has undoubtedly played a key role in the ETF marketplace, and in the last couple of years there has been a proliferation of funds that hedge as part of their investment strategy. Among the most popular ETF strategies have been foreign equity funds that hedge out currency exposure, but there also have been ETFs issued that hedge interest rate risk as well.
The need for interest rate hedging has not been that great as rates have generally continued to drift lower, but there has been a spotlight on currency-hedged equity funds as the U.S. dollar has gained strongly against most major currencies. ETFdb.com reported that through April 1, there are 26 such currency-hedged equity ETFs.
It bears repeating that the success of this segment—with over $40 billion in total net assets—has been helped by large moves in the currency market that have favored the U.S. dollar. Over the last one-year period (as of April 1), the U.S. dollar was up approximately 17% against the Japanese yen and in that same period, the euro had declined approximately 22% against the U.S. dollar.
The currency action has led to considerable outperformance of hedged funds over unhedged funds. In the last one-year period (as of April 1), the difference has amounted to more than 5% when investing in Japan and a 24% difference when investing broadly in Europe.
However, advisors and investors considering currency-hedged products need to understand the nature of the currency market before buying one of these ETFs. There are often large one-directional moves in currencies lasting several years that can then reverse direction for equally large moves.