The U.S. dollar's multi-year rally might not reverse soon — but it will eventually. (Illustration: Michael Austin/Theispot.com)

The proliferation of currency-hedged equity ETFs began several years ago, led by early adopters WisdomTree and Deutsche Bank. As such exposure gained popularity among investors, other fund providers joined the fray. The popularity of these ETFs can of course be attributed to the persistent trend of a rising U.S. dollar against many other major world currencies — a trend that ironically enough appeared after the dollar experienced an extended decline during the previous decade.

The importance of understanding the unpredictability of currencies cannot be overstated. The last decade’s decline in the dollar concluded just as the worst of the financial crisis arrived in 2008, which would seem like a peculiar point for the dollar to rally. Fast-forward to 2016: The U.S. is the only country discussing the possibility of raising rates and yet the dollar is declining against countries with negative interest rate policies.

There perhaps was no need to question the value of currency hedging when the trade was working, but lately, the rising-dollar trend has stalled out and the performance advantage has been hampered as well.

The recurring notion that hedged funds neutralize the currency exposure, or “hedge it out,” stands inaccurate, too. Those funds, as well as ETFs that seek to replicate such strategies, represent a bet against the home currency of the country, or in many cases the rest of the world. Making that sort of bet is fine, as long as a client realizes the effect a weak dollar will deliver.

The primary reason to use a currency-hedged ETF is to avoid the drag that a rising dollar can create on foreign holdings. There is a direct and simple cause and effect. Buying foreign equities unhedged is also buying the foreign currency, or a basket of currencies in the case of a broad-based ETF. If that foreign currency goes down versus the dollar, then it creates a drag on the holding; if that foreign currency rises, it creates a tailwind for the holding.

Evolution of Currency ETFs

Investment products in the currency-hedged realm have evolved as the dollar has rallied. A suite of ETFs exists that only hedges half the currency exposure so it always maintains exposure to the currency that is going up.

Another suite of currency-hedged ETFs attempts to dynamically hedge more of the portfolio, or less, based on market trends. This idea can work, and can also struggle due to unpredictable changes in the prevailing market trends — as no form of trend analysis can always be correct. At the very least, such a strategy adds a layer of complexity that an advisor would need to understand and monitor on clients’ behalf.

Currency hedging should neither be a passive endeavor nor should advisors speculate on the currency markets with client assets. However, a prudent active strategy comes into play when carefully utilizing passive ETFs as investment tools to provide clients with an appropriate allocation of currency-hedged ETFs and unhedged ETFs. Such an approach does not have to be limited to equities either. Currency-hedged fixed income ETFs have already hit the market and will likely keep expanding.

No investment strategy — whether hedging currency or maintaining unhedged exposure — will always outperform. Success requires advisors to understand the drawbacks of all ETFs in order to create a smoother ride for clients. It bears repeating that one reason such ETFs have become increasingly popular is because the dollar rallied for many years. That trend may or may not be ending now but it will end at some point, and a subsequent decline in the dollar could last for several years. Based on historical norms, currency-hedged ETFs will eventually lag and could lose popularity as quickly as they gained it.

— Read “3 Rules for Picking Alternative ETFs” on ThinkAdvisor.