Liquidity Key In iShares' New ETFs

iShares’ new funds offer a new twist on the currency hedging craze.

iShares’ suite of new currency- and interest-rate-hedged ETFs is interesting from a hedging perspective, but, perhaps more importantly, for the new and unique structure aimed at lowering overall costs they provide.

Only a few weeks ago, iShares launched their first currency-hedged ETFs, which included the iShares Currency Hedged MSCI EAFE ETF (HEFA), the iShares Currency Hedged MSCI Japan ETF (HEWJ) and the iShares Currency Hedged MSCI Germany ETF (HEWG).

Currency-hedged ETFs are nothing new. It seems that since the advent of “Abenomics” in Japan and the Federal Reserve’s tapering of quantitative easing here, there’s been a bonanza of currency-hedged ETF launches.

The real twist with the iShares products is that they literally hold the underlying “parent” ETF as their sole equity holding. For example, HEWJ simply holds the $13 billion iShares MSCI Japan ETF (EWJ | B-96) with a forward currency contract overlay to neutralize exposure to the yen relative to the U.S. dollar.

HEWG and HEFA follow the same structure. HEWG holds the iShares MSCI Germany ETF (EWG | A-97) and HEFA holds the iShares MSCI EAFE ETF (EFA | A-89), with forward currency overlays.

What’s interesting here isn’t just the fund-of-funds structure, but its profound impact on the fund’s liquidity, on the creation/redemption process, and on overall trading costs for the Authorized Participants. All of that trickles down to the end investor.

Take HEWJ as an example. In its first seven days of trading, HEWJ averaged only 2,000 shares a day in volume (and that includes 8,000 shares traded on Feb. 7). On most days, it’s only traded several hundred shares. Still, spreads have averaged only 4 cents, or 17 basis points—entirely reasonable for any international ETF.

With most ETFs—especially new launches—that trade this thinly, we would expect spreads far wider than 10 cents, translating to 30, or 40 basis points, if not higher.

Even HEWJ’s direct competitor that tracks the same MSCI index, the $415 million db X-trackers MSCI Hedged Japan ETF (DBJP | C-51), has average spreads of 5 cents, or 12 basis points even as it trades about $7 million on most days.

So how does HEWJ pull this off?

Advertised spreads are a function of many variables, including the overall risks and costs incurred by market makers. For example, market makers often hedge their ETF exposure by buying or selling the underlying basket of securities, especially for securities traded overseas on markets closed during U.S. market hours.

But with only one ultra-liquid holding—EWJ, which trades over $400 million a day at penny-wide spreads—those hedging costs and risks are significantly lowered, including currency risk. And since EWJ trades during U.S. market hours, it is literally the perfect hedge for the equity portion of the basket.

Lead market makers also take on risks with new launches when they float those new ETF shares from their inventory. Since HEWJ is created and redeemed using EWJ, as opposed to a basket of securities traded overseas in Tokyo, again, it’s cheaper to hedge that risk.

Using such a liquid ETF like EWJ for creations and redemption also lowers overall costs (in basis points) for Authorized Participants to create and redeem.

That also means even if you wanted to trade a large, but not creation-unit-sized lot of, say, 25,000 shares, you’re more likely to find a liquidity partner to put that trade on for you at a reasonable price.

The one big concern we often have with “ETFs of ETFs” is cascading expenses. Yet, HEWJ charges the same as EWJ—48 basis points. The gross fees for all the iShares products are significantly higher than their respective parent ETFs, but iShares is rebating fees to avoid the shareholder being “double charged.”

The one downside, and it’s probably not much of one, is that there’s likely to be some performance hit from hedging costs and the implied interest when you hedge out a foreign currency using forward contracts. That said, most developed nations are yielding barely anything, so carry costs should be minimal, at least with HEWJ and HEWG.

Coming down the pipeline, iShares also has a few interest-rate-hedged filings for ETFs that will hold blockbuster fixed income ETFs with an overlay of Treasury futures contracts.

In the coming months, I expect iShares to launch interest-rate-hedged versions of their $16.6 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-66) and $13.3 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-75).

Whether or not these new iShares products will pull assets away from their competitors based on their liquidity advantage remains to be seen. After all, HEWJ certainly has competition from the $12 billion WisdomTree Japan Hedged Equity ETF (DXJ | B-48) and DBJP.

And for HEWG, suddenly there are now more currency-hedged Germany ETFs than there are unhedged versions. Besides HEWG, there’s the WisdomTree Germany Hedged Equity ETF (DXGE) and the db X-trackers MSCI Germany Hedged ETF (DBGR | B-49).

Still, I think it’s great to see continued innovation in the space, and if issuers—such as iShares that have the existing products to pull it off—can come up with structures to lower overall risks and costs for everyone, including the end investor, then I welcome that.

There’s no telling how far the innovation will go, and I’m sure some will falter, but ETF investors continue to have a lot to look forward to.

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