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A Strong Dollar Idea

ETF Professor

The once-sluggish U.S. dollar is roaring back with vengeance. For the 90 days ended May 15, the PowerShares DB US Dollar Bullish ETF (NYSE: UUP) returned 4.7 percent.

While dollar strength is not yet pummeling international developed market equities, a familiar theme is emerging -- Some currency hedged exchange-traded funds tracking developed equity markets are topping their unhedged peers.

The iShares Currency Hedged MSCI EAFE ETF (CBOE: HEFA) is up 6.9 percent over the past three months while unhedged MSCI EAFE Index, one of the most widely followed benchmarks of ex-U.S. developed market stocks, is up just 2.7 percent over the same period.

What Happened

HEFA debuted in early 2014 as the currency hedged alternative to traditional MSCI EAFE strategies. HEFA is essentially the MSCI EAFE ETF (NYSE: EFA) with a currency hedged kicker. EFA, one of the largest developed market ETFs, is HEFA lone equity holding. HEFA has amassed $3.61 billion in assets since coming to market.

“Foreign stocks can be more volatile than a comparable portfolio of domestic stocks because they are exposed to changes in foreign-exchange rates,” said Morningstar in a note out Wednesday. “Over the long term, currency risk usually isn't well compensated, which can make currency-hedging attractive for those who would prefer to avoid the extra volatility.”

HEFA has a three-year standard deviation of just under 11 percent, according to issuer data.

Why It's Important

With the Federal Reserve expected to have multiple interest rate hikes in store between now and the end of 2018, it's possible the dollar continues gaining momentum against rival major currencies.

HEFA has the potential to deliver more upside for investors, particularly if the dollar gains strength against the yen and euro. Japan is the ETF's largest country exposure at almost 24 percent, while Eurozone economies combine for almost 30 percent of the fund's weight.

What's Next

“From its launch in January 2014 through December 2016, the fund outperformed 98 percent of its competitors because the dollar appreciated against many foreign currencies, benefiting a hedged strategy like this one,” said Morningstar. “But the dollar subsequently depreciated in 2017, causing the fund's total return to fall to the bottom of the category for that year. Over long periods, currency movements tend to have little impact on total returns.”

Morningstar has a Bronze rating on HEFA.

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