Currency Hedged ETFs Losing Luster

The headline-making trade of 2015—buying into currency-hedged ETFs WisdomTree European Hedged Equity ETF (HEDJ | B-47 ) and the WisdomTree Japan Hedged Equity ETF (DXJ | B-66)—is proving to be less than a foolproof idea this year.

The funds have been underperforming their unhedged counterparts year-to-date because the multiyear rise of the U.S. dollar has waned this year.

Returns on international equity funds come primarily from two sources: the price movement of underlying securities, and the impact of local currency fluctuations against the dollar. Currency-hedged ETFs take that currency exposure out of the equation.

In an environment where the dollar is rising, currency hedging can be a great idea. But so far this year, the euro has now risen 2.5% against the dollar. The yen has been even stronger, up now nearly 5% against the greenback year-to-date.

Chart courtesy of StockCharts.com

The primary reason behind the weakening dollar is that the market no longer expects the Federal Reserve to raise rates this year.

High Rates Supportive Of Currencies

Typically higher interest rates support the currency, but instead, the market is now increasingly concerned about the possibility of a global recession—one that could impact the U.S.—putting the outlook for higher rates on the backburner for now.

China’s slowing growth, emerging market troubles in the face of soft commodity prices, and increased stock market volatility tied to divergent central bank policies are all fueling fears of a global recession, and pushing demand for safe-haven assets.

The yen, specifically, has been strengthening partly as a reaction to China’s growing risk-off mood, and the subsequent flight to safety in the region.

“When China goes into a risk-off—that's because it's the most mature economy in the region—the yen becomes a slave to quality,” Larry McDonald, managing director, head of U.S. strategy, Macro Group at Societe Generale, based in New York City, said in a recent interview.

“It’s kind of insane, because [Japan is] the most leveraged economy in the world at 270-280% debt-to-GDP. But for some reason, in that region, if you've got $2 billion or $3 billion or $10 billion and you need to put it somewhere, Japanese bonds or the Japanese yen is the place to put it,” he added.

Going forward, it’s hard to tell whether the dollar will regain its upward momentum, or if a global recession will indeed take hold. There are those who say it may already be underway.

By definition, a recession is a contraction in growth and the rule of thumb is that a recession is marked by two-consecutive quarters of negative GDP growth.

Sub-2% Growth

The International Monetary Fund is projecting global GDP growth at 3.8% this year. But there’s a popular argument that anything below 2% feels like a recession, and that’s bad enough. If that’s the case, consider that the eurozone is seen growing under 2% this year and in 2017, the Organisation for Economic Co-operation and Development has said. Japan, meanwhile, is projected to expand 1.4% in 2016, according to the Bank of Japan.

As the performance of currency-hedged ETFs falter relative to their unhedged peers, investors have been pulling assets from these funds, as the table below shows.

The asset flows year-to-date stand in stark contrast to those of 2015, when HEDJ and DXJ were among the most popular ETFs, raking in $13.8 billion and $3.7 billion in fresh net assets, respectively.

Contact Cinthia Murphy at [email protected].