Currency Hedged ETFs Not Created Equal

High interest rates in emerging markets are paid, not earned, for currency-hedged ETFs like HEEM and DBEM.

Currency-hedged products like the Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM | F-61) and the newly launched iShares Currency Hedged MSCI Emerging Markets ETF (HEEM) strip out the currency risk for U.S. investors, leaving just the pure performance of the underlying stocks in local emerging markets.

With developed Europe in the doldrums and the U.S. looking frothy, hedged emerging market ETFs could appeal by reducing the volatility and uncertainty from currency moves while retaining exposure to the potential growth of EM economies.

Hedging out currency risk comes at a cost, however. This cost is directly related to the prevailing local interest rates in the countries in which the fund is investing (more accurately, in the difference between the rates of those countries and the U.S. rate).

In the case of emerging markets, this is a significant head wind to performance.

High-Interest-Rate Head Winds

How significant? My back-of-the-envelope number is about 5 percent per year. (More on how I got this in a moment.) Consider the interest rates in some of the countries in which emerging market ETFs have a huge stake: China, with a rate of 6 percent, India at 8 percent and Brazil at 11 percent. These high rates account for inflation—often high in emerging market countries—plus any perceived credit risk of the issuing country.

The key point: In a currency-hedged fund, you aren’t earning these rates. You’re paying them.

Looking Forward

Again, local interest rates effectively determine the embedded costs of hedging the currency. That’s because ETFs like HEEM and DBEM hedge their currency risk just like everyone else in the world, with forward contracts and other derivatives.

The derivatives themselves aren’t the problem. They simply reflect the inescapable arithmetic of hedging currency. A quick explanation: If the fund is hedging out the Indian rupee for the next month, it is short the rupee (to counteract the long rupee position in the Indian stock) and long the dollar. At the end of the month, it trades rupees for dollars.

The person on the other side of the contract needs to be compensated for missing out on the month’s interest earned on the rupee that she could have earned in an Indian bank (less that from the greenback). This cost is baked into the currency-forward contact.

And that brings me back to funds like HEEM and DBEM, which must maintain their currency hedge, month after month, year after year, effectively bearing the cost of the local interest rate.

A Drag On Returns

My estimate for the total annual currency hedging cost for HEEM is 4.9 percent. That’s the weighted average of the portfolio country weights and prevailing interest rates, less the U.S. rate.

Does this mean HEEM is doomed to lag its unhedged sister the iShares MSCI Emerging Markets (EEM | B-97) by 4.9 percent each year? Not at all. If emerging markets take off while their currencies plunge against the dollar—a topic for another day—HEEM and DBEM will crush their unhedged peers.

The point is simply this: Hedging currency comes with a price tag that drags on returns.

For Japan equities, that cost is tiny due to the low interest rate in Japan, which is part of the appeal of blockbuster ETFs like the WisdomTree Japan Hedged Equity ETF (DXJ | B-62) and the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-71). However, the cost is much higher for a basket of emerging markets. The cost won’t show up in the expense ratio, but it will flow through to the bottom line.

We face costs to hedge out risks every day—like insurance on cars and homes. When hedging currency risks in the emerging markets, the cost isn’t as obvious as an expense ratio, but it’s just as real.

Be sure to figure it into your buy decision.

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