ETF Winners & Losers If Dollar Rally Persists

October 28, 2016

Currency-Hedged ETFs Back In Focus

A spike in the dollar will also put currency-hedged ETFs back in focus for investors. These ETFs were extremely popular in 2014 and 2015, when the dollar was surging, but fell out of favor this year, as the currency stalled.

For example, the WisdomTree Europe Hedged Equity Fund (HEDJ) was the most popular ETF of 2015, with inflows of $13.9 billion, according to FactSet. In sharp contrast, the ETF is 2016's least popular ETF, with outflows of $7.4 billion.

When the dollar is rising, vanilla funds with international exposure face pressure as their holdings―which are denominated in foreign currencies―lose value when translated back into dollars. Currency-hedged ETFs offset these losses by shorting the foreign currencies in question. In the case of HEDJ, it shorts the euro to offset the underlying long euro position of its equity holdings.

HEDJ, like other currency-hedged ETFs, tends to outperform its vanilla counterparts in a rising-dollar environment and underperform in a falling-dollar environment.

Pressure On Large-Cap Equity ETFs

Though currency-related exchange-traded funds will be the most impacted, any significant increase in the dollar will reverberate throughout financial markets.

Many U.S. companies will have to deal with a much more challenging export environment as a strong dollar makes them less competitive. Those same companies will see their overseas profits reduced when converted back into dollars.

Stocks of these multinationals tend to be concentrated in large-cap indexes such as the S&P 500 (the percentage of products and services produced or sold by S&P 500 companies outside the U.S. was 44.3% in 2015). Thus, ETFs such as the SPDR S&P 500 (SPY) could face head winds from the dollar's ascent.

In the fixed-income markets, a strong buck makes it more difficult for foreign governments and companies to service their dollar-denominated debt. In turn, ETFs such as the iShares JP Morgan USD Emerging Markets Bond ETF (EMB), which has seen a lot of interest this year, may stumble if the Dollar Index spikes well above 100.

Contact Sumit Roy at [email protected].

 

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