The U.S. dollar index was on a downward spiral, dropping more than 5.2% year-to-date in reaction to growing doubts the Federal Reserve would actually raise rates this year. But that was until the Brexit vote succeeded.
This morning, the greenback had erased half its losses, rallying some 2.5% as the British pound slipped to a 30-year low and the euro hit a low of $1.09 against the dollar.
In the ETF market, this apparent reversal in trend could bode well for currency-hedged ETFs, or at least put these once-hot strategies back on the center stage of investor interest.
Consider the recent trajectory of the WisdomTree Europe Hedged Equity Fund (HEDJ | B-47). HEDJ is the second-biggest Europe-focused ETF in the market today, with $11.6 billion in total assets. It’s smaller only to the unhedged veteran, the Vanguard FTSE Europe ETF (VGK | A-97), with $13.2 billion. Both funds offer total-market, developed-Europe exposure, and are at the top of the segment.
Before the Brexit vote, buying into the currency-hedged exposure HEDJ offers—with an expense ratio that is nearly 5 times more than VGK’s—didn’t seem to make a lot of sense from a total-return perspective. Investors are shelling out 0.58% for a total market portfolio that’s underperformed the 0.12%-in-fees VGK by more than 2.5 percentage points:
However, this morning, it was the unhedged VGK that was leading in losses, losing some 8.5% following the surprising outcome of the Brexit vote, while HEDJ was down 6.3%. Friday’s price move pretty much closed the gap between the two, and alluded to the performance benefit a currency-hedged strategy might have over an unhedged counterpart going forward.
The chart below shows VGK’s and HEDJ’s year-to-date performance following Brexit. They are now toe-to-toe:
More About The Dollar Than Underlying
HEDJ’s portfolio allocates most heavily to France and Germany, which, combined, represent more than 50% of the portfolio. That compares with VGK’s focus on the U.K., which represents about 30% of the overall mix, and is the fund’s biggest country bet. But HEDJ’s recent underperformance is largely linked to the performance of the U.S. dollar.
Currency-hedged ETFs, by design, protect U.S. investors from the negative impact a strong U.S. dollar has on international stock returns. But when the dollar weakens, they can be underperformers.
When you own an international stock fund, your money is converted into, say, the euro, to buy the underlying securities abroad. Your gains depend on the performance of those securities, as well as on the performance of the currencies. If the euro weakens—or the dollar strengthens—you lose money when your returns are converted back to dollars.