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.