With international equities outperforming U.S. stocks year-to-date and for the past year, it’s no surprise that U.S. investors have poured $69 billion into international ETFs while pulling out about $30 billion from U.S. equity ETFs, according to the latest data from Credit Suisse.
But those investors run the risk of smaller relative returns or even possible losses if the currencies underlying those assets decline, which is very possible given the strength of the U.S. dollar.
For international stocks, “the most important lesson of the last two and half years has been the impact of the currency on any equity investment,” says Dodd Kittsley, head of ETF Strategy and National Accounts at Deutsche Asset & Wealth Management. “Currencies have hit investors where it hurts the most — in returns.”
For U.S. investors gains in foreign stocks can be wiped out or reduced after those gains are converted into U.S. dollars. A good example of this: the performance of the MSCI EAFE index, composed of large- and mid-cap stocks outside the U.S. For the 12 months ended March 31, the index, unhedged, lost 0.9%, but a hedged version of the index rose 17.1%. During that same 12 months, the U.S. dollar index gained almost 23%. (It has since declined a few percentage points.)
Investors have a choice: to hedge all of part of the currency risk or not, and that choice will likely depend on their view of the dollar in relation to foreign currencies. “If you have a view that the dollar will weaken, you want to be unhedged,” says Kittsley. “But if you have a view that the dollar will strengthen you want to be hedged. But most people don’t have a view on currencies, so why would they want currencies to drive their investment? Why not take currencies off the table?”
That’s apparently what many investors are choosing to do. According to Barron’s recent roundtable on global ETFs, just two ETFs — Wisdom Tree Europe Hedged Equity (HEDJ) and Deutsche X-Trackers MSCI EAFE Hedged Equity (DBEF) – have taken in about a third of all the inflows into ETFs this year.