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Currency-Hedged ETFs: Making the Case for U.S. Investors

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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.

All of Deutsche Bank’s currency-hedged ETFs are fully hedged with currency forward contracts, as is the WisdomTree fund.

The popularity of these ETFs is not surprising given the strength of the dollar for much of the year so far and the past performance of those ETFs. In 2014 DBEF gained 5.3%, while its ETF peers in the foreign large blend category lost 5% on average, according to Morningstar. HEDJ gained 6.5% compared to a 7.3% loss for its peers in the Europe stock category. Year-to-date, these ETFs continue to outperform their respective unhedged indexes.

But hedged ETFs have their critics. Some say the hedging reduces the diversification of the portfolio. Catherine LeGraw at GMO says the hedging is often not what it purports to be because many multinational companies in these indexes collect revenues and have costs denominated in the local currencies where they do business.

Kittsley doesn’t buy that argument. “A 10% return in a local market is a 10% return in that local market. Hedging insures you get that 10% return in the underlying stocks. It protects investors for the translation of U.S. dollars into foreign currencies and back to U.S. dollars during the holding period.” There can also be a cost to hedging. There’s the opportunity cost if the returns would be greater without the hedging, and there’s the actual cost to hedge. That’s driven by the differential in interest rates. Hedging a portfolio of Brazilian stocks where interest rates top 13% is expensive; hedging a portfolio of European stocks, where rates are near or below zero is cheap. In countries like Switzerland where rates are negative, investors are getting paid for the hedge.

Given these differentials, Morningstar analyst Kevin McDevitt suggests in a recent commentary that investors adopt “the 50% rule — hedging half of one’s foreign-equity exposure and leaving the other half unhedged.” He recommends investors hedge developed market currencies, which have low or negative interest rates, and leave emerging market equity positions unhedged. The unhedged emerging market positions will also add to diversification. But the hedged portfolios, writes McDevitt, will be less volatile.

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