Currency-Hedged Everything: HEFA’s Big Day

I’ve written about the rise of currency-hedged ETFs many times, and even made hedged-Europe one of my picks for 2015. But the fund that’s really catching my eye —and the eye of a lot of investors—is the iShares Currency Hedged MSCI EFA (HEFA | D-41).

The premise behind the MSCI EAFE Index has been pretty simple for decades: If you invest in all of the developed markets outside North America, you can create diversification while still getting developed-markets equity exposure. And for a long time, real diversification is what you got. Here’s the correlation between EAFE and the S&P 500 Index going back to the Super Nintendo era:

While the correlation benefits we saw in prior decades may have tapered off, many investors still look to EAFE-based products as the core of their international exposure. In fact, one of the largest ETFs in the U.S. tracks it—the iShares MSCI EAFE ETF (EFA | A-91), with $53 billion in assets.

Deutsche Bank, one of the early pioneers in currency-hedged ETFs, launched its version of the concept in 2011—practically the dark ages for currency-hedged products. It slowly accumulated around $1 billion in assets. That was before the broad international market tanked in December:

While one of those pioneering Deutsche funds, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-71) was already starting to gain assets, once the global ex-U.S. markets tanked and started their recoveries, assets in both products skyrocketed.

And the discrepancy in performance between the unhedged EAFE (the bottom line in the top panel) and the other two products has been highly rewarding. In just the past six months, the two hedged versions (which are nearly identical in total return) beat the unhedged version by almost 13 percentage points.

The reasoning here remains the same as it has for all of the hedged products: With the U.S. seemingly in a strong global position, it’s hard to bet against the dollar, and that’s what you do when you invest unhedged outside the U.S. The EAFE Index, in particular, holds such a broad basket of countries that it’s really about the dollar and not about the yen or the euro.

And almost universally, those major currencies have been going one way against the dollar: down.

Even the insane pop of the Swiss franc when it abandoned its euro peg wasn’t enough to do more than momentarily interrupt the collapse of the world’s currencies in the wake of the dollar.

But while I get the incentive for investors, what’s slightly more puzzling is the incredibly rapid flows into the iShares version of the currency-hedged EAFE fund. Year-to-date, HEFA has pulled in almost its entire asset base—more than $600 million. Just yesterday it pulled in more than $300 million.

The Authorized Participants Playing Favorites

Why the love for the second-place, more expensive, less liquid product?  I have a few theories, and all of them may play a role:

1. HEFA just hit its one-year anniversary this week. That may put it on the screen of many investors who might otherwise be sitting out on a new fund.
2. For a single creation unit, HEFA charges less to the authorized participant (AP)—both funds have 50,000 unit blocks, but HEFA charges $100, versus $4,650 for competitor DBEF. On a $300 million creation, we could argue it shouldn't matter, but money is money.
3. Perhaps even more importantly, all an AP has to do to make new shares of HEFA is to buy a pile of the unhedged version and deliver some cash to iShares. In other words, that’s all HEFA holds: the unhedged ETF, and some currency hedges. DBEF requires rolling up a whole basket of international stocks. There are pros and cons to this approach (including, possibly, tracking difference issues), but to the extent the AP community can suggest one product versus the  other, I imagine they point people to the thing that’s easiest for them, regardless of what might be best for the long-term investor.

Dan Weiskopf at Access ETF always says: Structure matters. I can’t think of a clearer case in point.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected] or on Twitter @DaveNadig.