Case Against Currency-Hedged ETFs

March 17, 2014

What if the vast success of an ETF such as the Japan-focused DXJ is based on a fallacy?

With activist central banks around the world manipulating interest rates, releasing round after round of quantitative easing and experimenting with new ways to stimulate their economies, investor anxieties about currency devaluations and outright currency collapses have intensified recently.

In response to these fears, fund issuers have brought to market a dozen new currency-hedged equity ETFs since last fall.

Despite the strong marketing message that these funds send—that they’re more stable and predictable alternatives to their un-hedged counterparts—most of the new ETFs have been very slow to catch on, as we described in the recent article “New Currency-Hedged ETFs Slow Out Of Gate.”

Are investors missing out by not jumping on this bandwagon, or are they right to be hesitant and skeptical about whether this a good idea in the first place?

Will a currency hedge reduce volatility, protect from a turbulent macro environment and deliver the desired returns in the end? The answers might surprise you.

One Wager, Not Two

Conventional wisdom says that in international investing, you have to be right twice: once about the direction of the foreign equity market; and about the direction of its currency compared with your own currency.

If you get either one wrong, your overall returns suffer or even turn to losses. So on the surface, currency hedged equity products remove part of the uncertainty and simplify the decision to invest.

While this line of thinking seems seductively logical, it ignores the fact that the two components of this equation frequently offset each other in the short term and are inextricably linked in the long term.

Let’s start with the short term.

A Short-Term Look

At the end of 2012 and first half of 2013, the Japanese yen experienced a sustained decline against the dollar and other currencies, while the Japanese stock market climbed steadily in nominal terms.

The most popular Japanese currency hedged ETF at the time—the WisdomTree Japan Hedged Equity Fund (DXJ | B-51) quickly grabbed the headlines by leaving other unhedged Japanese ETFs like the iShares MSCI Japan ETF (EWJ | B-97) in the dust.

Naturally, this awakened investor appetite for more hedged products with the potential to produce similar results in other parts of the world where currency depreciation seemed inevitable.

So let’s examine the hedged and unhedged results from investing in the Japanese equity market over the short and medium term. As proxies, I’ve chosen the MSCI Japan index and its hedged version. Both can be easily accessed by investing in two exchange-traded funds: the unhedged iShares MSCI Japan ETF (EWJ | B-97) and the hedged db X-trackers MSCI Japan Hedged Equity Fund (DBJP |C-55).

Below is a table summarizing the results:

MSCI Japan Index MSCI Japan Index $US Hedged
1-Yr Return 15% 28%
5-Yr Return 71% 72%
1-Yr Standard Deviation of Daily Returns 1.38% 1.52%
5-Yr Standard Deviation of Weekly Returns 2.40% 2.73%





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