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.