A Fresh Look At Hedged ETFs

Should investors be wary of the inverse exposure that’s baked in to currency- and interest-rate hedged ETFs?

ETFs offering hedged exposure have never been more popular. Whether a country ETF that hedges out currency risk or a bond fund that tamps down interest-rate risk, these products take the basic coverage of a “plain vanilla” fund and subtract out an unwanted element of performance.

Did you ever wonder if the hedging aspect of these ETFs carries with it some of the risks—real and imagined—associated with inverse and levered funds?

After all, a currency-hedged product like the iShares Currency Hedged MSCI Japan ETF (HEWJ) is effectively the iShares MSCI Japan ETF (EWJ | B-96) (a plain-vanilla country fund with full currency risk) with an inverse yen overlay.

In 2011, the fear and loathing aimed at inverse and levered ETFs reached fever pitch. They were blamed for everything from duping unwitting investors to creating volatility in capital markets. Much of this drama was overblown, but pure-play inverse and levered ETFs can be tricky to use and remain banned from some advisor platforms.

In my view, currency- and interest-rate-hedged products like HEWJ avoid the biggest “shoot yourself in the foot” risk that long-term investors bear when using inverse and levered ETFs on their own.

That risk is the failure to rebalance exposure regularly. Investors using inverse and levered ETFs get into trouble when they “set it and forget it”—an approach that can lead to unpleasant results in the long run. Investors using a -2x product are unlikely to get anything resembling -2x returns unless they regularly rebalance their coverage.

Products like HEWJ or the WisdomTree Japan Hedged Equity Fund (DXJ | B-48) avoid this outcome in part because they reset accounts for movements in the base asset—Japanese stocks in this case. You can think of the currency hedge as a managed overlay in part of an all-in-one solution.

This doesn’t make for perfect protection against currency moves. The funds’ monthly reset can’t account for gains or losses in between the reset periods. If the fund goes up sharply at the start of the month, for example, investors are exposed to currency risk on the amount of the gain until the next reset.

Still, this risk is small compared with a poorly executed do-it-yourself approach using an inverse ETF like the ProShares UltraShort Yen ETF (YCS) combined with unhedged EWJ, where an investor’s failure to rebalance her YCS exposure could produce real distortions from the intended outcome.

The all-in-one solution has other pluses too, including lower costs, fewer tax headaches and the elimination of the need to commit additional capital. (YCS costs 95 basis points annually ($95 for each $10,000 invested), issues K-1s at tax time and would still require an additional 50 percent capital outlay.)

The downside of the all-in-one solutions includes a lack of flexibility—such products aim to hedge 100 percent at all times—and the need to sell off your old unhedged exposure (like EWJ), which could be a taxable event.

Taking a step back, it’s important to remember that even a perfectly executed hedge has downsides.

By design, these hedges protect against some downside but forgo some upside. HEWJ will lag unhedged EWJ if the yen appreciates. HEWJ’s FX hedge also has structural sensitivity to short-term interest rates here and in Japan—a nonfactor now, but an aspect that could drag on returns someday.

Similarly, fixed-income products that hedge out interest rate-risk will lag if rates fall. Reducing interest rate risk also reduces yield—an undesirable trait for income-focused investors.

In all, hedged ETFs provide a straightforward solution for those aiming to separate risks they want from those they don’t—one where investors will get rewarded or punished based on their actual views, while avoiding some of the challenges of implementing those views.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected].