As the U.S. dollar slid roughly 12 percent from the start of 2017 through mid-February 2018, currency-hedged investments became a millstone for investors. The hedges sapped potential gains, leading to sharp underperformance relative to unhedged global investments.

Now the worm has turned. The dollar has rebounded roughly five percent in the past four months, with many market strategists predicting further gains for the dollar. Currency-hedged ETFs are now posting more robust returns than their unhedged rivals.

For example, the WisdomTree Europe Hedged Equity Fund (HEDJ) has rallied about eight percent since the dollar began its rebound. The Vanguard FTSE Europe ETF (VGK) has traded flat in that time.

Joe Tenaglia, WisdomTree’s asset allocation strategist, suggests focusing on heding’s short term-impacts is unwise. Instead, he and his WisdomTree colleagues believe that hedging brings a different set of longer-term benefits.

“Currency effects can add to or reduce gains, but they’ll always boost volatility,” he says. In that vein, a WisdomTree study found that currency hedging consistently led to lower standard deviations of returns versus unhedged portfolios over three, five, 10 and 20-year time frames through this year’s first quarter. This was particularly evident during the 10-year time-frame, where currency-hedged exposure to the MSCI EAFE reduced standard deviation by four percentage points.

On a more prosaic level, Tenaglia wonders why investors even want to speculate on the future direction of the dollar against currencies like the euro and the yen. “We can say with some certainty that European stocks will be higher a decade from now, but we have no idea where the euro will go.”

Dispelling The Cost Myth

Investors might assume that the use of currency forward contracts to provide hedging would create extra costs and a drag on returns.

In fact, the opposite has been the case. Interest rates in the U.S. are currently higher than in Europe and Japan, enabling ETFs sponsors like WisdomTree and others to borrow at lower European and Japanese rates and invest proceeds in higher-yielding U.S. rates. This “carry trade” provided a 2.3 percent boost to returns for the WisdomTree Europe Hedged Equity Fund in the past 12 months, for example. That more than offsets the fund’s 0.58 percent expense ratio.

In fact, as this week’s Fed rate hike shows, the interest rate gap is widening further. As reported in the Wall Street Journal this week in an article discussing the U.S. and Europe, the gap between the two central banks’ key policy rates is expected to widen to around 3 percentage points by year-end 2019, compared to the current gap of 2 percentage points.

The carry trade doesn’t apply to all markets. “The truth today is that hedging foreign currencies is only expensive in some cases—particularly emerging markets such as India and Brazil—but can be inexpensive for Europe and Japan,” WisdomTree research director Jeremy Schwartz wrote in a blog post on the topic.

You can also think of currency-hedged investing in the context of export competitiveness. When the Japanese yen loses value against the dollar, as it has recently, the nation’s exporters tend to benefit from lower global prices for their goods. Trouble is, a falling yen will blunt returns for unhedged investors in Japanese equities.

“If you are a believer in Japanese equity markets, we think you should hedge because many of the companies are reliant on the currency to weaken,” says Tenaglia. WisdomTree found that there is a 65 percent negative correlation between the yen and Japanese large-cap stocks.

The WisdomTree Japan Hedged Equity Fund (DXJ), which has a 0.48 percent expense ratio, focuses on export-oriented dividend-producing Japanese companies. As of the end of the first quarter, it had returned 10.45 percent annually over the past 5 years, compared to an 8.21 percent return for the iShares MSCI Japan ETF (EWJ), the largest Japan country fund with assets of nearly $20.2 billion. Moreover, the iShares fund’s 0.49 percent expense ratio is a tick higher than its hedged rival.

Strategic Vs. Tactical

As you’d imagine, the strategists at WidsomTree see currency-hedged funds as strategic holdings. Yet some investors still prefer deploying them as tactical trading vehicles when the dollar is rallying and avoid them when the dollar is weakening.

So, what’s the outlook for the dollar? Writing on his marctomarket blog, respected Brown Brothers Harriman currency strategist Marc Chandler notes a growing sentiment among currency traders for a pullback in the dollar, which would be “corrective in nature, after the strong performance record since the middle of Q1.” That argues for unhedged exposure, if those predictions pan out.

For investors looking to build long-term exposure to global markets, the merits of currency-hedged exposure are clear. Of course, if European and Japanese interest rates eventually move above comparative U.S. interest rates, the carry trade deployed by currency-hedged funds would become a clear drag. But that’s a story for another day.