Currency-Hedged ETFs Lower Volatility

Dennis Hudachek

Dave and Devin wrote blogs recently about how currency movements can affect the returns of international ETFs.

While I won't go into the details again, in a nutshell, when you buy an international ETF traded on a U.S. exchange, you're basically shorting the U.S. dollar relative to the currency of the country you're exposed to. So, your returns are impacted by movements in both the underlying securities and local currency.

With the current crisis in Europe causing a rally in the U.S. dollar—again due to the resurgence in the risk-off trade—the few currency-hedged ETFs currently available are starting to look interesting.

These funds include the db-X MSCI Emerging Markets Currency-Hedged Equity Fund (NYSEArca:DBEM - News), db-X MSCI EAFE Currency-Hedged Equity Fund (NYSEArca:DBEF - News), db-X MSCI Brazil Currency-Hedged Equity Fund (NYSEArca:DBBR - News) and WisdomTree International Hedged Equity Fund (NYSEArca:HEDJ - News).

These funds are designed to outperform similar nonhedged funds when the dollar strengthens (and conversely, underperform them when the dollar weakens) by utilizing forward currency contracts to hedge their currency exposure.

It seems simple, but a major factor that's also often overlooked is the negative correlation we've been seeing between movements in the broad equity markets and dollar over the past several years.

During recent crises and sharp equity sell-offs, investors have repeatedly piled into U.S. Treasurys and the U.S. dollar as a "flight to safety" trade.

Conversely, when the risk-on trade is back in play and the broad equity markets have rallied, we've largely seen weakness in the dollar relative to most currencies, save the Japanese yen and Swiss franc, which have "safe haven" appeal themselves.

Because of this interesting trend, these funds can be viewed as more than just currency-hedged funds—they're actually performing as de facto lower-volatility versions of their nonhedged peers.

Take a look at the historical returns charts between the MSCI Emerging Markets Index—tracked by popular funds like the Vanguard MSCI Emerging Markets ETF (NYSEArca:VWO - News) and iShares MSCI Emerging Markets Index Fund (NYSEArca:EEM - News)—and the MSCI Emerging Markets Currency-Hedged Index, which DBEM aims to track.

We'll compare the indexes, since DBEM still has a short trading history. Pay special attention to the sell-off during the 2008 financial crisis and the recent European debt crisis.

Indexes:MSCI EM Hedged vs. MSCI EM
View photos
Indexes:MSCI EM Hedged vs. MSCI EM

Source:Bloomberg

The difference in volatility is even more profound when comparing the MSCI Brazil Index—tracked by the iShares MSCI Brazil Index Fund (NYSEArca:EWZ - News)—and the MSCI Brazil Currency-Hedged Index, which DBBR tracks.

Indexes:MSCI EM Hedged vs. MSCI EM
View photos
Indexes:MSCI EM Hedged vs. MSCI EM

Source:Bloomberg


If you take a look at the returns between EWZ and DBBR since this summer, it's clear that DBBR held up much better than EWZ in September, when the Brazilian real plunged against the dollar.

Indexes:MSCI EM Hedged vs. MSCI EM
View photos
Indexes:MSCI EM Hedged vs. MSCI EM

Source:Bloomberg


As these charts show, while the returns of nonhedged funds like EEM, VWO and EWZ have been juiced on the upside from a weakening dollar, their short dollar exposure has also caused them to plunge even harder during sharp equity sell-offs. They've almost acted like funds with a slight touch of leverage.

Meanwhile, during the current crisis, losses in currency-hedged funds like DBEM have been buffered as the dollar rallied. With over $85 billion in assets under management between EEM and VWO, I'm still surprised that the currency-hedged version of these funds, DBEM, only has $4.5 million in assets.

Trading volume is also still very light in DBEM and the other Deutsche Bank currency-hedged products, so investors should be aware of spreads if they choose them and use limit orders.

Of course there's no guarantee that this interesting trend between equities and the U.S. dollar will continue.

But while it does, for those looking for international exposure with less volatility, these currency-hedged funds may be worth a closer look.

 

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