Case Against Currency-Hedged ETFs

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:

While the hedged version would have returned 28 percent in the past year—almost double the unhedged index, the gains over the whole five-year period are basically identical.

Standard deviation/volatility metrics actually favor the unhedged position. The lower volatility of the unhedged index is not a surprise in this case, since the currency and equity prices in an export-driven economy like Japan’s are inversely related to each other in the short term.

Long-Term Focus­­­­

Now let’s turn to the long term. I think here it’s important to not only look at statistical measures, but to take a more fundamental approach and figure out if there are valid economic reasons that justify currency hedging of foreign equities.

A quote from Warren Buffett’s 2011 shareholder letter will help us approach this from the correct angle:

“We, at Berkshire, define investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.”

When viewing international investing through this prism, it becomes clear that currency hedging is not only not necessary, but it introduces additional risk.

A productive asset with real earning power, i.e., a successful company, will by definition grow in real value. And in the long haul, all currencies adjust against each other based on their purchasing power (purchasing power parity, PPP).

So, no matter what the currency in which the asset is denominated does relative to the investor’s own currency, PPP will ensure that, ultimately, a profitable investment can be converted back into more goods and services than what was given up when the asset was acquired.

Now imagine you obtained an asset that, as described above, keeps multiplying in real terms. However, you have a currency hedge attached to it and that part of the bet goes against you. This would severely limit or even reverse the real gains the investment would have provided otherwise.

Let’s look at an actual example to illustrate the point.

Continuing with Japan, let’s see what would have happened if we invested there over a long-term horizon and either hedged our yen exposure or, conversely, went unhedged.

Below is a chart of the Nikkei, in yen and in dollars, going back 30 years:

The monthly volatility is about 6 percent in both cases, but the difference in return between hedged (NKY in blue) and unhedged (NKYUSD in green) exposure is staggering: 1 percent versus 3.7 percent compounded annual return over 30 years.

During this period, Japan experienced the bursting of a monstrous real estate bubble and the subsequent long and painful deleveraging of the private sector. In addition, Japanese business was extremely slow in adjusting to a changing and increasingly competitive global environment.

Despite all that, gross domestic product grew from $1.4 trillion to $6 trillion over this 30-year period, and companies were indeed able to extract profits from the economy that tripled their worth to a U.S. investor.

Importantly though, some of this gain came in the form of currency appreciation (the yen doubled its purchasing power against the dollar) and some came in the form of higher nominal stock prices.

The overall results of the unhedged investment are broadly in line with Japanese businesses’ performance over this period, but no one could have predicted the split between the two components of the return in advance.

That brings us back to my earlier point that nominal equity prices and the currency they are quoted in are fundamentally connected and reflect economic reality in tandem.

Hedging out the currency actually leaves a long-term investor exposed to macroeconomic factors other than the success or failure of those businesses.

In future blogs, we will return to this topic with examples from other markets as well as explore if currency hedging has a place in other asset classes and under what conditions.

For now, the takeaway is this: If you take a long-term perspective and invest because you believe an economy will prosper and its firms will make profits, there’s no good reason to hedge. It won’t necessarily reduce volatility, and it has the potential to hurt you even if you’re otherwise correct in your investment decision.If, on the other hand, you wish to make a bet that a country’s currency will depreciate while its stock market goes up in nominal terms, then currency-hedged ETFs are just the tool you need.

However, this type of wager is really speculation and not investing. It depends not on the profitability of the underlying businesses, but on macroeconomic forces. And those forces are notoriously hard to predict.

At the time this article was written, the author held a long position in EWJ. Contact Boris Valentinov at [email protected].