Currency hedged ETFs outperform, pick up inflows as dollar gains

The headquarters of BlackRock in New York. BlackRock, WisdomTree Investments and Deutsche Bank are among the companies starting new currency-hedged funds this year to take advantage of a flow of some $3.9bn into currency-hedged ETFs so far this year.

Reuters

New York

US investors who believe the dollar’s 2014 surge will continue are pouring money into exchange-traded funds that invest in foreign markets but hedge the currency part of the bet.

BlackRock, WisdomTree Investments and Deutsche Bank are among the companies starting new currency-hedged funds this year to take advantage of a flow of some $3.9bn into currency-hedged ETFs so far this year.

There are now 35 US listed currency-hedging ETFs managing $19.3bn in assets, compared with only about $6.7bn in assets in 2011, meaning total assets in currency hedged ETFs have nearly tripled over the past three years, according data from Lipper and ETF.com.

A currency hedged ETF strips out the foreign currency return of a given fund by investing in foreign currency forward contracts, and rolling those contracts, typically on a monthly basis.

The largest asset gatherer has been the WisdomTree Hedged Europe ETF, which since January has added about $2.6bn, growing four-fold to $3.5bn.

So far, the dollar’s rise has made that strategy pay off handsomely. For example, investors who bet on Japanese stocks via the unhedged iShares MSCI Japan ETF have lost 0.7% over the past three months, as the yen sank against the dollar. Its hedged counterpart, the iShares Currency Hedged MSCI Japan ETF, is up about 12%.

“Sometimes currency is not that relevant in the scheme of things, but times like now, when currencies are moving very quickly...it can make all the difference,” said Art Laffer Jr, a Nashville investment manager who now has about 25% of the global equity strategy he runs in currency hedged ETFs.

He bought the iShares Currency Hedged MSCI Germany ETF earlier this year and also owns the WisdomTree Japan Hedged Equity Fund. He would hedge more of his foreign stocks portfolio if he could find more individual country funds offering that add on, he said. The US dollar soared to a seven-year high against the yen last week and reached its highest level in more than two years against the euro on Thursday, November 6.

“We’re a couple of years into a prolonged multi-year cycle” of dollar strengthening, said Dodd Kittsley, head of ETF strategy at Deutsche Asset and Wealth Management in New York, noting that historically, periods of dollar strength and weakness run roughly 6 to 8 years long.

“We have a lot of conviction because of the massive divergence in central bank policy,” he said, referring to the way the Bank of Japan and European Central Bank have signalled their intent to further monetary policy easing, at the same time that the US Federal Reserve reigns in its stimulus programme. Deutsche has several currency hedged ETFs; its Deutsche X-trackers MSCI EAFE Hedged Equity ETF, has nearly quadrupled in assets since January, and now holds just under $1bn in assets.

Currency-hedged ETFs like these are mainly aimed at investors who want to bet on foreign stocks; those who are less interested in those foreign markets and just want to bet the dollar will strengthen could buy a currency-focused ETF such as the PowerShares DB Bullish Dollar Index Fund or the WisdomTree Bloomberg US Dollar Bullish Fund. The PowerShares Fund is up 8.13% so far this year, while the WisdomTree Fund is up 5.73%, according to Thomson Reuters data.

Still, while developed markets like Europe and Japan have proven to be attractive regions for US investors to currency hedge, the same is not true of countries such as Brazil and Mexico where high interest rates can bite into the cost of currency hedging and weigh on returns.

“We haven’t seen a lot of uptick in emerging markets currency hedging yet,” Kittsley said. “The cost of hedging tends to be a bit more” in countries like Brazil and India, where interest rates are higher than in the US. The cost of currency hedging is roughly akin to the spread in interest rates between an investor’s home country and the country where the currency is being hedged.

In Europe and Japan, where the interest rate differential is much smaller, the cost is trivial. In fact, with foreign interest rates lower than in the US, investors can actually be paid slightly for the hedge when going from the euro or yen to US dollars.