Are Currency Hedged ETFs Overlooked?

Currency-hedged ETFs haven't gotten much love from investors lately.

Three of the largest ETFs in the space—the WisdomTree Europe Hedged Equity Fund (HEDJ), the WisdomTree Japan Hedged Equity Fund (DXJ) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF)—have had combined outflows of $3.5 billion through the first nine months of the year.

That's on top of the eye-popping $19 billion worth of outflows the trio saw in 2016.

It's understandable why investors have been losing faith in these funds. Based on the U.S. Dollar Index, the greenback has slid so far this year by 9.4% against rival currencies. A falling dollar makes for subpar returns for currency-hedged ETFs compared to their unhedged counterparts.

HEDJ, for example, is up 13% this year compared with 23.3% for the unhedged Vanguard FTSE Europe ETF (VGK); DXJ is up 11%, compared with 14.4% for the unhedged iShares MSCI Japan ETF (EWJ); and DBEF is up 11.3%, compared with 19.7% for the unhedged iShares MSCI EAFE ETF (EFA).

YTD Returns For HEDJ, VGK, US Dollar Index

Performance Evens Out

Even though investors haven't shown much interest in currency-hedged ETFs recently, maybe they should. That's according to a recent research report from BlackRock, which concluded that investors are better off hedging nearly all of their foreign currency exposure over the long term.

Between 2014 and 2016, U.S. investors were rewarded for hedging their foreign equity exposure as the dollar steadily climbed. This year, the opposite is the case, as the dollar has sagged.

However, investors shouldn't pay too much attention to those vagaries in performance, because currency movements are notoriously difficult to predict and tend to even out, noted BlackRock analysts.

Risk, No Reward?

"These differences between hedged and unhedged returns have historically tended to narrow in the very long run, and investors should not expect to be rewarded for holding currency risk over time," said the report.

Rather than boost returns, foreign currency exposure has tended to increase a portfolio's volatility. By hedging, the volatility of a portfolio holding foreign securities is reduced.

"Currency risk adds significantly to overall portfolio volatility in eurozone and U.K. equities," explained the authors of the report.

Japan is an exception. Because of the yen's propensity to move in the opposite direction of the domestic stock market, unhedged exposure to the country may reduce volatility.

Still, the authors suggest that, as an asset class, U.S. investors should fully hedge their exposure to international developed-market equities.

Hedging Important For Bonds, Too

Meanwhile, the case for hedging may be even stronger for fixed income. Especially now, with yields historically low, "FX [currency] swings can swamp bond portfolio income," warned BlackRock.

Unhedged bond holdings may double annualized portfolio volatility, according to the authors.

Again, the report's recommendation is for U.S. investors to fully hedge any international developed-market government bond exposure, investment-grade credit exposure and high-yield exposure.

Investors may be taking heed. The Vanguard International Bond ETF (BNDX)―which is hedged against currency fluctuations―has seen inflows of $2 billion this year, making the $8.1 billion fund the second-largest international bond ETF on the market, as well as the second-largest currency-hedged ETF on the market.

No Need To Hedge EM Exposure

The one area that BlackRock doesn't see benefiting from currency hedging is emerging markets.

When it comes to emerging markets, "FX exposure and carry (the income from interest rate differentials) are key sources of total return for local-rate portfolios. And hedging is often either impractical or prohibitively expensive," the authors noted.

The usual rules of thumb for dealing with foreign-exchange risks and opportunities do not apply in emerging market investing, they concluded.

Contact Sumit Roy at [email protected]