Currency-hedged ETFs are as hot as the dollar.
While some funds have been listed for several years, hedging foreign currency risk in an automatic and systematic way through index ETFs has only recently attracted investor interest.
According to XTF.com, of the $44 billion invested in currency-hedged equity exchange-traded funds, $18 billion has arrived in 2015, a response to further yen weakening and a rapidly declining euro. Although 30 such funds are listed, the spoils primarily have flowed to seven funds and three fund companies.
Whether these flows largely amount to performance chasing or represent a conceptual shift in the philosophy around non-dollar holdings is yet to shake out.
“If you are matching assets and liabilities, why take currency risk unless you have a view,” said Jeremy Schwartz, director of research at WisdomTree Investments, New York, which manages 13 currency hedged ETFs, including the $15.6 billion WisdomTree Japan Hedged Equity Fund and the $15.3 billion WisdomTree Europe Hedged Equity Fund.
“It could be a long way away, but this type of activity in the currency markets could be the impetus for a change in institutional investor policy benchmarks,” said Dodd Kittsley, head of ETF strategy at Deutsche Asset & Wealth Management in New York, which manages 12 currency-hedged ETFs to MSCI Inc. indexes.
Both WisdomTree and Deutsche Bank run “traditional” ETFs, holding the underlying securities and entering into one-month forwards to lock in the home-market currencies against the dollar. BlackRock Inc.'s iShares unit took a slightly different tack when entering the market last year. Its four offerings simply provide an overlay to its existing unhedged offerings of MSCI indexes.
After consultation with clients several years ago, WisdomTree reconsidered its internal index for Japan and Europe to emphasize companies and industries that would most benefit from a weaker currency. The company's currency-hedged indexes target dividend-paying companies that draw significant revenue from foreign sources (at least 20% for Japan and 50% for Europe.)
Over longer periods of time, of course, these currency fluctuations, particularly as they relate to global firms, affect input prices and product markets such that “the real rate of return will ultimately reflect what's happening with currency,” said Raman Subramanian, managing director and head of index applied research at MSCI in New York.
“Over the short run though,” Mr. Subramanian acknowledged, “patterns and cycles in the currency markets are swayed by monetary policy decisions by the regimes involved in the issuance and maintenance of a particular currency.”
Whether the products are appropriate and price competitive remains to be seen, but a handful of pension funds — including the New York State Common Retirement Fund, Employees Retirement System of Texas and the New Jersey Pension Fund — reported currency-hedged equity ETF holdings as of Dec. 31. All three held shares of WisdomTree Japan Hedged Equity Fund, while NYSCRF also reported holding WisdomTree Europe Hedged Equity.
Through March 13, according to Morningstar Inc., the unhedged iShares MSCI EMU ETF gained 3.4%; the hedged version from iShares, launched in August, returned 17.9%; a hedged offering from Deutsche Bank, launched in December, gained 18.4%; and WisdomTree Europe Hedged Equity was up 19.8%. By comparison, the dollar is up 15% against the euro on the year.
Recent comments from asset managers — that currency overlay desks can't keep their lines free — coupled with ETF flows would indicate investors, both institutional and retail, show a bias toward action with the return of the strong dollar, even if ultimately they choose to stay unhedged. While choosing to hedge away/outside of the primary portfolio through an overlay adds complexity, the current set of ETFs does not fully replicate dynamic or partially hedged strategies. Relative to their unhedged equivalents or similar exposures, the largest currency-hedged ETFs are similarly priced between 0.35% and 0.6%.
Two hedged emerging markets ETFs from iShares and Deutsche Bank charge 0.7% and 1.19%, respectively, for the opportunity to hedge in less liquid foreign currency markets.
Even in an environment where the forward cost is de minimis, operational complexities still stand in the way of a separately managed currency overlay or one that attempts to generate alpha from a more dynamic view of currency shifts.
“We believe that stocks provide more of the diversification benefits, rather than the currencies,” said WisdomTree's Mr. Schwartz. n