Are Dynamic Currency-Hedged ETFs Worth It?

Mitigating Currency Risks With Actively-Managed ETFs

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Smart beta exchange-traded funds (ETFs) have grown to nearly $300 billion in assets under management as of early-2016. According to BlackRock, a leading ETF issuer, these figures could grow to upwards of $1 trillion by 2020 and $1.4 trillion by 2025. Volatility-focused smart beta funds tend to be the most popular, but currency-hedged funds could become increasingly important due to the rising political risks around the world.

In this article, we will take a look at how dynamic currency hedged funds operate and whether international investors should consider them for their portfolios.

Dollar Is an Important ‘Factor’

Smart beta ETFs have become increasingly popular alternative to market capitalization weighted funds over the past couple of years. By focusing on value, momentum, dividends, and other ‘factors’, these funds help investors achieve greater income, higher returns, or other benefits than conventional funds. The evidence supporting these claims is mixed and depends on a variety of factors, but they are a valuable tool for mitigating risks.

Currency-hedged ETFs have become a popular smart beta option given the U.S. dollar’s significant rise relative to foreign currencies. Between 2011 and 2016, the U.S. dollar appreciated nearly 30 percent, or about 5 percent per year, which means that any gains in foreign markets over that time frame were mitigated by losses in foreign currency valuations.

Currency-hedged ETFs helped improve returns by offsetting the impact of foreign currencies for these markets.

Of course, currency-hedged ETFs didn’t (or wouldn’t have) performed nearly as well during the five-year period leading up to 2008 when the dollar fell about 25 percent, or about 4.5 percent per year.

Investors in currency-hedged ETFs during that time would have lost out on 4.5 percent per year in foreign gains due to losses in the U.S. dollar’s valuation. Investors would have also missed out on the other benefits of diversifying currencies beyond the dollar.

Capitalizing on the Dollar’s Moves

Dynamic currency-hedged ETFs aim to solve these issues by actively managing exposure to foreign currencies. Unlike actively-managed funds, these ETFs use an established set of rules to determine their exposure to foreign currencies. The goal isn’t necessary to trade currencies for an incremental profit, but rather, mitigate the risks associated with a downturn in the dollar while participating in some upside gains when it appreciates.

For example, the WisdomTree Dynamic Currency Hedged International Equity Fund (DDWM) provides investors with a hedged alternative to the iShares MSCI EAFE ETF (EFA) with about $400 million in assets under management. The dynamic currency hedged fund outperformed both EFA and similar fully-hedged funds, like the Deutsche X-Trackers MSCI EAFE Hedged Equity ETF (DBEF) by avoiding the Sterling’s decline and euro’s troubles.

The fund works by looking at interest rate differentials, technical momentum, and purchasing power parity to determine the right amount to hedge.

According to WisdomTree, these signals enable its dynamic currency hedged funds to generate 1 percent per year of return from the dollar’s gains while protecting investors when the dollar declines. The goal isn’t necessarily to win 100 percent of the time, but rather, remain exposed to some gains and protect against most declines.

Important Risks to Consider

The largest risk for international investors using dynamic currency hedged ETFs is that they will make the wrong calls when hedging currencies. In many ways, this is the same argument that can be made against any actively-managed fund or smart beta strategy that takes a more hands-on approach than a passively-managed index fund. Investors should exercise caution when analyzing the performance of these funds under these circumstances.

For example, a dynamic currency hedged fund may underperform fully-hedged funds during periods of a rising dollar since it’s not likely to be 100 percent hedged.

The same fund could fail to hedge significantly enough during a period of dollar declines, which could lead it to underperform passive indexes by a wider-than-expected margin.

Investors should keep in mind that any recent outperformance could be due to short-term (1-5 year) currency dynamics rather than any underlying strategy. As a result, it’s important to consider long-term performance when available or take a detailed look at the strategies used to understand how they might perform during various currency movements.

The Bottom Line

Smart beta ETFs have become increasingly popular over the past couple of years. According to BlackRock, these funds could become a trillion dollar asset class in just a few more years. International investors may want to consider dynamic currency hedged funds as a potential opportunity to mitigate currency risks. These funds enable investors to avoid secular declines in the dollar while still retaining some of the upside potential if it rises.