Next For Europe: Emerging Market Currency-Hedged ETFs

The downward spiral of emerging markets is pushing spooked equity investors towards currency-hedged exchange-traded funds (ETFs) to eliminate the corrosive effect of foreign exchange movements on their return. ETF providers are pushing out new products in the U.S. to meet investor demand, and it will only be a matter of months before we see an equivalent ETF for European investors, predicts Nik Bienkowski, co-chief executive officer at ETF provider, WisdomTree Europe.

“Exotic” Out Of Fashion

2015 has been a poor year for emerging markets - 'exotic is out of fashion and investors are retreating to the perceived safety of the developed world. Emerging market GDP growth in the second quarter slowed to 3.8 percent year-on-year – the weakest rate since the aftermath of the global financial crisis in 2009, according to figures compiled by Capital Economics. The research house predicts this downturn to continue into the third quarter.

China's economic slowdown and state intervention to weaken its currency has had a knock-on effect on its neighbours, who in turn have devalued their currencies. Leading analysts remain bearish on emerging market currencies, citing China's slowdown, the imminent prospect of rising U.S. interest rates, falling commodity prices and lethargic economic growth.

Hedging Currency Can Provide Comfort

Spooked equity investors in emerging markets are concerned that a falling currency can hit their returns – a double whammy if equity returns are also poor. Previously, investors that bought into emerging market growth were also buying into the currency, explains Bienkowski. But now that currencies are falling, the trend for currency-hedged ETFs has kicked off.

"If [investors] have an emerging market mandate, they might choose currency-hedged ETFs to neutralise the effect of [the] currencies falling," said Bienkowski.

To that end, BlackRock's ETF arm, iShares, launched 11 new ETFs this summer in the U.S. that included the iShares Currency Hedged MSCI South Korea ETF and the iShares Currency Hedged MSCI Mexico ETF, to complement its existing iShares Currency Hedged MSCI Emerging Markets ETF.

From The U.S. To Europe

Currently, these products are still in their infancy – there are only three dedicated emerging market currency-hedged ETFs, which are all listed in the US. But the speed with which investors have flocked to these ETFs is worth noting. They have grown from around $55 million at the end of last year to $390 million of assets under management today, according to data compiled by research house ETFGI, Bloomberg and WisdomTree Europe.

There are currently no emerging market equity currency-hedged ETFs listed in Europe, but this will likely change, predicts Bienkowski.

"Currency hedging has grown, why doesn't [an emerging market hedged product] exist in Europe? The likelihood [is that we will] see one in the next six months, based on the fact it is offered in U.S. but not in Europe," said Bienkowski.

He anticipates that the next move by providers will be to offer products that hedge against a basket of currencies.

Cost Of Hedging

But investors should remember that hedging against emerging market currencies is a different beast to hedging major currencies like the dollar, euro and yen. It is more costly due to the interest rate differential, which is why historically there haven't been that many products, according to Axel Merk, president and chief investment officer at U.S.-based Merk Investments.

The higher interest rates are in the country of the currency an investor is trying to hedge against, the higher the cost of hedging. Countries like Brazil and Mexico have persistently high interest rates, particularly when compared to the U.S. and Europe, where rates have hit rock bottom. Spreads are also wider in emerging markets.

"But now that emerging markets currencies have crumbled, these products are coming to market," said Merk.

But crucially, currency movements in emerging markets do not always correlate favourably with stock market movements. For example, broadly speaking, Japan's currency has tended to fall as its stock market rises, which makes hedged products extremely popular with currency-conscious U.S. and European investors. Investors can pick up stock market returns and convert them back into their home currency, with no exposure to a falling yen. But emerging market currencies tend to mimic their stock markets, thus reducing the effectiveness of currency-hedged strategies. They strengthen as capital flows into the country, and weaken when capital flees.

Actively Managing FX Risk

Given the nuances of emerging market currencies and high levels of volatility, smart investors can separate their foreign exchange risk from their ETF and actively manage it instead, advises Merk.

"We live in a world where we are going to have more volatility – if anything in currency markets it is not yet where it will be in a few months. Volatility in major currencies been reasonably low," said Merk. "I do predict volatility in all markets is going to be higher so if one wants to play with currency-hedged products that is fine: my preference is to actively manage those currencies."

Ultimately, U.S. interest rates play an important role. A rate hike and stronger dollar could spell further bad news for emerging market currencies, making currency-hedged ETFs all the more worthwhile for investors.