The ETF Hedge That's Lost Its Edge

May 23, 2016

[This article appears in our June issue of ETF Report]

Currency-hedged ETFs are intended to be the solution to a problem that's always existed, but really wasn't on most investors' radar until recent years—that of the impact of currency on foreign security returns.

Currencies are known as one of the most difficult markets to time, and an asset that's practically impossible to forecast. That'll never change.

Some investors may have simply viewed currency risk as one of many market risks that can't be avoided; others who did recognize it as a problem may have seen no simple or affordable solution to manage that problem—that is, until the advent of low-cost currency-hedged ETFs.

But if currency exposure represents a perennial risk for investors who own international stocks in their portfolios, it seems the appeal of the solution in an ETF wrapper is anything but a given.

A Bit Of History
Currency-hedged ETFs first began popping up almost a decade ago, but their rise to mainstream stardom really began in late 2012 when Japan's Prime Minister Shinzo Abe was re-elected on a platform of reform known today as "Abenomics." The "three-arrow" plan involving fiscal stimulus, monetary easing and structural reforms designed to spur growth in the long-deflationary economy almost immediately weakened the yen.

As the yen weakened against the U.S. dollar, funds such as the WisdomTree Japan Hedged Equity Fund (DXJ | B-64) and the Deutsche X-trackers MSCI Japan Hedged Equity ETF (DBJP | B-71) emerged as bona fide solutions to nonhedged equity exposure that was bleeding returns on the currency move. Investors began to take notice of the outperformance as they gained a clearer understanding of the impact that currency had on equity portfolio returns.

In 2013, investors were faced with the wide dispersion between the performance of DXJ and DBJP against the unhedged iShares MSCI Japan ETF (EWJ | B-94). DBJP shelled out twice the returns of EWJ in the 12-month period (Figure 1).

Just like that, currency-hedged ETFs became the tool du jour, finding their way into portfolios everywhere.

DXJ was a pioneer of sorts in the space. The fund, which came to market in 2006, saw its methodology change to include a currency hedge in 2010. WisdomTree saw an opportunity to capture the wild moves in the yen at the time. Later in 2012, DXJ was again tinkered with to include an export tilt, which would benefit more from a weakened yen.

The early days were stop-and-go for DXJ, with, at best, inflows of $370 million in one year, and at worst, $740 million in net redemptions the next, according to FactSet data. But by 2013, shortly after Abe took office, DXJ began raking in investor dollars as it started to outperform, and it ended the year as one of the most popular ETFs of 2013, seeing roughly $10 billion in net creations.

The relative low cost of currency hedging in an ETF structure only helped fuel the ascent of DXJ and ETFs like it as institutional-caliber tools for everyday investors.

Hedging foreign currency exposure has always been considered an expensive proposition, particularly in countries where short-term interest rates are higher than those in the U.S. In an ETF wrapper, costs aren't so prohibitive. Consider that DXJ's hedged portfolio of Japanese stocks costs only 0.48% in expense ratio, or $48 per $10,000 invested—less than many smart-beta ETFs on the market today.

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