A Crowded Currency Hedged ETF Trend

March 12, 2015

An astonishing $12 billion has flowed into the WisdomTree Europe Hedged Equity Fund (HEDJ | B-51) in the past year, and truth be told, it’s been money well invested.

But the increasingly powerful flows into HEDJ make me wonder if investors aren’t starting to chase returns. Consider this: More than $7 billion has flowed into the ETF market’s most popular fund so far this year, and more than $2 billion of that has come this month alone.

Yes, the eurozone is poised for a rebound—in terms of a near-term reversion to the mean and, in the longer term, perhaps a more lasting bull run based on the European Central Bank’s commitment to fight deflation through quantitative easing.

Hedging Has Fueled Returns

Consider that the currency hedge on HEDJ, for U.S. investors, has made a winner of a neutral investment in the past 12 months. The blue line in the chart below is the CurrencyShares Euro ETF (FXE | B-98), the euro-dollar cross in an exchange-traded wrapper.

There’s an elegant mirror-like quality to the chart that isolates the currency factor rather cleanly. Were it not for the currency hedge, HEDJ would be about flat.

Parity In Sight

Growing consensus is that the euro will reach parity with the dollar before long.

It now takes about $1.06 to buy one euro. That’s down from about $1.38 a year ago and nearly $1.48 back in the spring of 2011, just before the eurozone's debt crisis began to deepen. Much of this move, recently in particular, is based on the ECB’s being committed to carry out an aggressive QE program, so more euro weakness against the dollar seems in the cards.

That said, markets are imperfect and are notorious for overshooting underlying fundamentals.

So, it stands to reason that these powerful inflows into HEDJ and other currency-hedged strategies such as the Japan-focused WisdomTree Japan Hedged Equity Fund (DXJ | B-57) and the MSCI EAFE Index-focused Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-71) might be a bit much.

Trade Becoming Crowded

Again, HEDJ has pulled in about $12 billion in the past year, while DBEF and DXJ have pulled in $4.7 billion and $1.6 billion, respectively. This year alone, industrywide flows into currency-hedged strategies total about $12 billion into all of the ETF market’s strategies.

As if the wave of inflows were cresting, on Monday, March 9—the sixth anniversary of the postcrash market nadir—HEDJ and DXJ together pulled in more than $1 billion. That’s serious money and, again, in a single day.

Look at the chart below that depicts flows for HEDJ and DXJ in the past year to gauge how recent flows are looking more and more like a mass of conformity.

A Word Of Caution

To be sure, what’s going on in the eurozone and the global economy since the financial crisis is truly unprecedented. I’m talking about how deleveraging is slowing down recovery, how aging populations have slowed productivity gains in the macroeconomy and how technology is crimping job-market recovery.

Maybe that’s why executives in the ETF industry, such as Dodd Kittsley of Deutsche Bank, are going out of their way to explain why currency-hedged ETFs make sense. For U.S. investors worried about how currency exposures are creating unwanted volatility in their portfolios, currency-hedged products like HEDJ and DXJ and DBEF take it right off the table.

My concern is that many investors who are jumping on the bandwagon are doing so not for this relatively sophisticated motivation of controlling volatility, but rather because the weakening euro or the weakening yen, for now, have created outsized returns for U.S. investors. That’s the story behind the vast inflows of both DXJ and HEDJ in the past two years, and that’s not just me saying that. Plenty of advisors are telling me as much as well.

These funds have become multibillion-dollar blockbusters because of alpha seekers. But they could be in for a surprise once the trend ends or even if the movement goes into hibernation for a while as the foreign exchange market consolidates.

The takeaway is this: It’s probably fair to expect parity between the euro and the dollar. But once parity is reached, it might make sense to think through this currency-hedging decision again and carefully. Parity is just a symbolic threshold, but doing a bit of portfolio due diligence regarding currency hedging is never a bad idea, even if that means staying the course.


At the time this article was written, the author held no positions in the securities mentioned. Contact Olly Ludwig at [email protected] or follow him on Twitter @OllyLudwig.

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