How To Get Currency Hedging Right

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.

… Then It Gets Murkier

But let’s look at what has happened to the highly profitable currency-hedging play of 2013 and 2014 involving the dollar-yen cross. The yen slid 18 percent in 2013 and another 12 percent in 2014 as Japan’s prime minister went all-in with a yen-weakening monetary policy, giving those invested in Japanese stocks via a currency-hedged Japan fund like DXJ protection against these big drops.

But this year, the yen is nearly unchanged against the dollar, and the difference between returns on hedged and unhedged Japan funds is essentially gone, calling into question the entire motivation for hedging out currency exposure.

The two Japanese equities funds in the chart below—the hedged iShares Currency Hedged MSCI Japan ETF (HEWJ | D-38) (in black) and the unhedged iShares MSCI Japan ETF (EWJ | B-99) (in blue)—are identical but for the currency hedge, helping to isolate the currency variable. The red line is the CurrencyShares Japanese Yen Trust (FXY | B-99), which is the yen-dollar cross wrapped up in an ETF.

Charts courtesy of StockCharts.com

The shifting trend in the yen-dollar cross has, for now, obviated the difference in returns between hedged and unhedged funds and points to one of the basic notions in investing; namely, trends don’t last forever. It’s all but assured that an unhedged Japan fund like EWJ or an unhedged eurozone fund like EZU will produce superior returns to their respective hedged counterparts.

In fact, academic research suggests that, over time, the currency variable is a bit of a wash; the advantages of hedging currency risk over time get canceled by the fact that the trend turns back and forth.

A Need For Clear Choices

The idea of shifting trends takes us back to IndexIQ’s plan to offer five funds that will hedge out currency risk on just half of each of the ETFs it plans to market. This approach dovetails with the idea that currency exposure is a wash over time—it just arrives at that insight in a more active way.

I’ve heard WisdomTree’s Director of Research Jeremy Schwartz make a similar case—that currency-hedging half of a portfolio can make sense, at least for those who lack conviction about the currency variable.

But it doesn’t mean it’s the right call, particularly because currency trends have historically tended to last a long time relative to other trends in financial markets. That means you could profit, get killed or enjoy a bit of each if you owned one of these ETF options.

And this is why some advisors will seek to manage currency risk in an active way, addressing just what the “long term” means to individual clients. That means they might hedge when there’s a clear trend, trim the sails at times or totally change course as they deem necessary.

The unambiguously good news in all this—as the IndexIQ regulatory filing makes clear—is that an increasingly diverse array of ETFs is becoming available to address currency-related volatility in a thoughtful and systematic manner.

But these tools will not, in and of themselves, save investors from themselves. Fickleness is a death-knell to successful returns. Whatever the approach to currencies in international investing, investors need to make their beds and sleep in them. Otherwise it’s sure to be a nightmare.

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