The ETF Hedge That's Lost Its Edge

[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.

Second Act In Europe
The next act for currency-hedged ETFs' rise to popularity was staged in the eurozone. Not too long after European Central Bank President Mario Draghi said he was willing to do whatever it took to get growth in the region started again, he began intervening with quantitative easing measures in 2014—right as the U.S. was getting ready to wrap up its own QE.

That year, it was the WisdomTree Europe Hedged Equity Fund (HEDJ | B-47) that landed among the year's 10 most popular ETFs, attracting more than $5 billion, followed by nearly $14 billion in net inflows in 2015. The Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-73), too, all but became a household name, with $14 billion in net inflows in that two-year period.

Their resonance with investors encouraged issuers to get creative, and expand their lineups of currency-hedging tools with ETFs that offer so-called dynamic hedges, or even 50% hedges, at an ever-growing pace. In 2013, eight new currency-hedged ETFs were launched on U.S. exchanges, followed by 15 new launches in 2014. Last year, 57 new currency-hedged ETFs made their debut.

The sky seemed to be the limit. And then things changed.

Dollar Reverses Course
Much of the furor fueling demand for these funds centered on a U.S. dollar that did nothing but rise against currencies such as the yen and the euro. With the Fed signaling last year it was going to raise rates—which it did in December—the monetary divergence between the dollar and the euro and yen seemed locked in place.

An environment where the dollar is strengthening is great for currency-hedged ETFs, because that's when they tend to outperform unhedged counterparts. Investors had seen it happen, and chased that performance in recent years, betting on a continued stronger dollar.

The dollar has in fact weakened this year as currency markets digest the fact that the Federal Reserve no longer seems ready to raise rates in the U.S. Developed nations' currency markets have stopped behaving, to the benefit of funds such as DBJP and HEDJ.

Instead, weak economic data and inflation readings here are quickly turning the outlook bearish for the dollar—which hit a one-year low in May. Without rate hikes, that so-called divergent Fed policy isn't really all that different—or divergent—from that of other developed countries.

Meanwhile, despite the Bank of Japan's aggressive quantitative easing, pointing to continued pressure on the yen, the currency actually went the other way, rising to an 18-month high as recently as May. In the past 12 months, the yen has surged roughly 12% against the U.S. dollar.

The euro, too, has been beating the odds against easy-money policies, and gaining ground against the greenback. In the past year, the euro has rallied roughly 3% (Figure 2).


In this environment, the appeal of developed-market currency-hedged portfolios fades, as these funds no longer deliver the outsized performance relative to their unhedged counterparts they're known to offer when the dollar is strong.

So far in 2016, investors have been yanking money from these funds. DXJ faced $3.2 billion in net redemptions in the first four months of the year, and HEDJ bled $2.9 billion—they're two of the largest, most popular currency-hedged ETFs on the market today.

If the dollar's best days are indeed behind it, as some are now suggesting, it could be that the hot currency-hedging trend completely runs out of steam, or new products that change with the movement of the dollar may take root. The early signs of a has-been blockbuster suggest as much.

Or it could be that the newer, innovative currency-hedged ETFs offering dynamic and partially hedged ETF solutions get their day in the sun as investors look for new ways to navigate the unpredictable sea of currency moves.

The new-to-market WisdomTree Dynamic Currency Hedged International Equity Fund (DDWM), investing in developed-market equities outside the U.S. and Canada, has already seen net creations of some $240 million year-to-date—a solid start for a new fund.

What happens next, only time will tell.