How To Get Currency Hedging Right

May 11, 2015

The powerful inflows into a number of currency-hedged strategies in the past two years have created huge buzz about the power of currency-hedging ETFs. But the still-expanding success of these ETFs has also given rise to murkier questions about what the long-term role of currency hedging should be.

Whatever their judgments, investors would be wise to come up with a consistent approach to currencies and do their very best to stick to their plans. Let’s not forget that rule No. 1 for investors is developing a plan and sticking to it. Not doing so can be quite expensive and deleterious to returns.

All this came into focus when IndexIQ recently put a number of currency-hedged equity funds into registration that will hedge half of their portfolio but leave the other half unhedged. You have to love the malleability of an ETF wrapper that affords this 50-50 approach to currency hedging.

But isn’t it indecisive?

Well, maybe, but the innovative folks at IndexIQ—the ETF sponsor that was just acquired by New York Life—are no pushovers. Which is to say that there’s research suggesting such a noncommittal approach to currency investing does make sense—at least over the longer term.

But I’m getting ahead of myself, as the current craze for currency-hedged ETFs isn’t really about the long term. It’s about dampening currency-related volatility and, let’s make it plain, enhancing returns right now.

A Great Trade … Right Now

In an immediate sense, currency-hedged ETFs like the two hugely successful ones from WisdomTree—the WisdomTree Europe Hedged Equity Fund (HEDJ | B-54) and the WisdomTree Japan Hedged Equity Fund (DXJ | B-67)—are, if nothing else, the right products at the right time.

For U.S. investors grappling with central banks around the world that are engaging in currency-weakening quantitative easing policies, neutralizing the dollar’s strength against the euro and against the yen has protected solid returns in both the Japanese and European local equities markets.

HEDJ and DXJ as well other successful currency-hedged strategies such as the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-72) take the currency variable right off the table, as the year-to-date chart below comparing two identical eurozone equity funds makes clear.

The black line is the hedged iShares Currency Hedged MSCI EMU ETF (HEZU | D-43); the blue line is an identical, but unhedged, version of HEZU, the iShares MSCI EMU ETF (EZU | B-79). The red line is the CurrencyShares Euro Trust (FXE | B-98), which is a euro-dollar cross wrapped up into an ETF. Notice that FXE is down about 7 percent—the same amount that separates the two equity funds. That picture clearly shows what’s at stake for U.S. investors investing these days in euro-denominated equities.

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