Performance Gap

Over the last couple of years, the dramatic appreciation of the U.S. dollar against the euro, yen and other currencies has led to a huge performance gap between ETFs that hedge currency exposure and those that don’t. For example, the unhedged iShares MSCI EAFE (EFA) ETF fell by about a half of 1% for the year ended May 31. During the same period, its currency-hedged iShares counterpart, which enjoyed the price appreciation of foreign markets but didn’t feel the pain of a strengthening dollar, rose nearly 16%.

While the latest currency seesaw isn’t unprecedented, it drives home the point that currency movements are an important component of foreign fund returns. When foreign currencies are strong compared with the dollar, U.S. investors in funds that don’t hedge get a boost from currency translation, and they lose out when foreign currencies weaken and the dollar gets stronger.

The strong performance of currency-hedged ETFs, most of them covering Europe and Japan, has led investors to pour over $60 billion into about 30 such offerings since 2012. WisdomTree is the oldest and largest player in the space, although BlackRock and Deutsche Bank also have a number of actively traded currency-hedged offerings.

Too Late To The Party?
The question for investors new to currency hedged ETFs is whether this is a good time to start, and even whether they need to hedge currencies at all. Opinions are all over the map on both issues.

Morningstar analyst Tim Strauts believes that while the ETFs “could be a good solution for the tactical investor who has a view on future currency movements,” he cautions, “Long-term investors may be better off in a traditional unhedged fund, which typically has lower expense ratios, doesn’t have the added cost of currency hedging and has a lower correlation with U.S. stock funds, which makes it a better portfolio diversifier.”

Luciano Siracusano, chief investment strategist at WisdomTree, says that both tactical and long-term investors can benefit by including currency hedged ETFs in international allocations. “Investors have become sensitive to the impact of currency movements, and they’re asking if it’s worth subjecting their portfolios to that risk over the long term,” he says. “Since 1987, there has been no added return generated by having currency exposure. But there has been more volatility. Why wouldn’t you hedge out currency risk if you’re not being compensated for it?”

The majority opinion seems to be that while currency hedging is probably a good idea, the bulk of returns generated by a strengthening dollar may be behind us for a while. In an interview with ETF.com, Bill Bernstein, author of several books on index investing, called the recent stampede into currency hedged ETFs an example of “performance-chasing, closing the barn door after the horses have escaped.” While he says hedging currency exposure can be useful, “you have to have a consistent strategy. If you’re going to hedge your currency exposure, then you should do it 100% of the time. Starting to hedge after a period of high hedging returns is a bad idea.”

Rusty Vanneman, chief investment officer at CLS Investments, notes that last year currency hedged ETFs represented about 25% to 30% of the international exposure in a typical firm portfolio. Now the stake is less than half that.

“This is not a great time to be initiating positions in currency hedged ETFs,” he says. “While the dollar has had an incredible run, it appears overvalued by a fair amount.” He’s also concerned about the “off the charts” inflows the ETFs have experienced. “When something is that hot, it’s a contrarian signal not to get in,” he says.

Vanneman adds that using currency hedged ETFs excessively or at the wrong time may have the unintended consequence of reducing diversification and increasing portfolio volatility. “Over the long term, unhedged international ETFs actually provide better diversification and less correlation to other assets because of their currency exposure,” he says. “And while currency hedged ETFs may be less volatile than those that aren’t hedged, they actually increase portfolio volatility by reducing diversification.”