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New Wrinkles For Currency Hedging ETFs

Cinthia Murphy

At the beginning of the year, ETF.com’s Matt Hougan called it: 2015 would be the year of currency hedging.

Now, as we approach the end of the year, it should be noted that currency hedging in ETFs has been a hot trend, as inflows reflect. Just as important, though, performance has stalled in many of these funds, even as the segment continues to welcome new and interesting takes on the theme.

After the huge success last year of the WisdomTree Japan Hedged Equity ETF (DXJ | B-68), which went on to become a $10 billion ETF in a matter of months in 2014, and perhaps the poster child for the currency-hedging ETF phenomenon, 45 out of 234 new ETF launches this year have been currency-hedged strategies.

The biggest ETFs in the segment, the WisdomTree Europe Hedged Equity ETF (HEDJ | B-50) and DXJ have $19 billion and $15 billion in assets, respectively—$34 billion in two ETFs alone. Impressive when considering those inflows came in approximately the last 18 months.

Clearly, investors are starting to understand that when you invest in international stocks, currency moves matter.

Yen Devaluation The Trigger

If we were to pinpoint the event that put currency hedging on investors’ radars for good, it would be the election of Japan’s Prime Minister Shinzo Abe in 2012. After he took office, he began pursuing policies that would weaken the yen.

Soon afterward, investors began to see what a currency’s devaluation can do to a country’s stock market.

Abe, and the weakening yen, unleashed a wave of currency-hedged ETF launches that’s showing no signs of slowing down. In fact, this week, the latest ETFs to join the segment also happen to be first-of-a-kind funds. They are currency-hedged China ETFs.

There are several reasons hedging currency exposure in a portfolio of Chinese stocks suddenly seem like an appealing idea. For years, China supported an implicit peg between the yuan and the dollar, which made the need for currency hedging practically nonexistent for U.S. stock investors with exposure to Chinese equities. But back in August, China took steps to devalue the yuan in a move that surprised the market.

Currency-Hedged China Funds Arrived

There’s also the issue of increased access to Chinese stocks. China’s mainland stock market—securities known here as “A-Shares”—are increasingly accessible to U.S. investors. There are already at least eight ETFs in the market today offering exposure to Shanghai-and Shenzhen-listed securities.

Thus, it only makes sense that with that backdrop, currency-hedged China ETFs would eventually make it to market. This week, Deutsche Bank rolled out the Deutsche X-trackers CSI 300 China A-Shares Hedged Equity ETF (ASHX), which is a currency-hedged version of the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-53), a $573 million fund.

The prospectus indicates that ASHR will be ASHX’s primary investment. ASHX comes with an expense ratio of 0.85 percent, five basis points more than that charged by ASHR.

Hong Kong-based CSOP Asset Management also launched a pair of China-focused ETFs this week, one of them the CSOP MSCI China A International Hedged ETF (CNHX). And there’s at least one other currency-hedged China ETF already in registration.

Popularity Doesn’t Equate To Performance

If investors are tuned in to the fact that currency exposure impacts stock returns, and they are buying into the currency-hedged ETF craze, they are also faced with the reality that hedging may be cool, but it doesn’t always means outperformance.

Consider the performance of DXJ—2014’s market darling—and its unhedged counterpart, the iShares MSCI Japan ETF (EWJ | B-98) over the past one year:

A lot of that performance dispersion can be tied to the strength of the dollar relative to the yen. But so far in 2015, that chart looks very different:

The upward momentum the dollar was facing has waned in 2015 as the market awaits a Federal Reserve move that would signal its confidence about the strength of the U.S. economy. A much-anticipated rate hike has yet to materialize.

The yen, in turn, is now flat against the dollar, after having been down by 5 percent against the dollar earlier this year. The same can be seen in the euro. The euro is still down about 7 percent against the dollar in 2015, but it had been down as much as 13 percent. It has clearly recouped some ground.

The impact of that change in the trajectory of the dollar is evident when you look at the performance of a fund such as HEDJ and the unhedged iShares MSCI EMU ETF (EZU | A-84). In the past 12 months, HEDJ outperformed EZU by roughly 9 percentage points.

But looking at a year-to-date 2015 chart, HEDJ’s edge over EZU is far diminished as the dollar loses momentum:

Charts courtesy of StockCharts.com

Without a strong and rising dollar, currency-hedged ETFs can actually underperform their unhedged counterparts.

It’s All About Having Tools

The mixed bag of prospects raises the question of whether investors should worry about currency hedging long term, or if they should worry about timing these things right.

“Some portfolio managers and ETF providers insist that over the long run, currency moves end up being a zero-sum game, so there is no need to focus on them,” said Dave Garff, president of Walnut Creek, California-based Accuvest Global Advisors. “Other portfolio managers and ETF providers contend that currency moves are significant and long-lasting, and thus are worthy of consideration as portfolio construction tools.

“We believe the latter to be true. If you get the currency direction wrong, it can have significant effect on the returns,” he said in a recent commentary.

The 50/50 Fund Arrives

Whether or not you have a view on currency hedging, there are also new ETFs in the market that alleviate the burden of having to make a decision.

IndexIQ recently launched three ETFs that are only 50 percent hedged—they only hedge away half of the foreign currency impact.

The funds, listed below, are a direct response to investor demand for an easier way to time the toggle between hedged and unhedged exposure, according to IndexIQ CEO Adam Patti:

“Market timing is a big question for anybody, particularly in the FX [currency] market, where it’s just extremely volatile and such a huge market and so liquid,” Patti said. “What we found was that they were mistiming the markets, and that is never a good thing.”

The idea here is that by maintaining a steady 50 percent hedge, rather than toggling between hedged and unhedged, investors would face less volatility, and a smaller need to rebalance allocations, Patti says.

“It’s a lot of work, and it’s costly,” Patti said. “We found that because some advisors were realizing they couldn’t time the markets, they were actually splitting their allocations anyway. They were going 50/50 in many cases.”

Whether that’s a perfect solution to managing currency risk on an equity exposure remains to be seen. But when it comes to currency hedging and ETFs, innovation is allowing investors to do a lot of things they never could before.

Contact Cinthia Murphy at cmurphy@etf.com.

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