Currency-Hedged ETFs Are 2015’s Hottest Trend

 

 

Currency-hedged exchange-traded funds (ETFs) are perhaps the hottest trade in 2015.

Since the beginning of the year, over $33 billion has flowed into these ETFs, which hold foreign equities but neutralize the foreign currency exposure.

The WisdomTree Europe Hedged Equity ETF (HEDJ), for instance, has experienced inflows of nearly $13 billion, the most of any ETF. And the Deutsche X-Trackers MSCI EAFE Hedged Equity ETF (DBEF) isn’t far behind with inflows of over $9 billion.

Of course, the popularity of these funds has been driven by a strong U.S. dollar, which has gained over 20% in value against the euro over the past year.

However, the “hedged” moniker can be very misleading. Here’s why…

As a hypothetical example, let’s say you have a portfolio full of ETFs.

Like many investors, you own the SPDR S&P 500 ETF (SPY) for large-cap U.S. stock exposure. You understand the importance of asset class diversification, so you also own the popular Vanguard Total Bond Market ETF (BND).

For your foreign equity exposure, you own HEDJ, as well as the WisdomTree Japan Hedged Equity ETF (DXJ).

Are you diversified? No way!

You’re actually unhedged. By that, I mean you’re unprotected against a decline in the U.S. dollar because everything you own is effectively denominated in dollars.

In fact, it’s actually quite difficult to quantify your exact exposure to the dollar because of increased globalization.

For example, the largest holding in DXJ is Toyota Motor (TM) (the shares that trade on the Tokyo Stock Exchange, not the American depository receipt). Around three-quarters of Toyota’s vehicle sales come from outside of Japan, so the company already benefits when the dollar strengthens and the Japanese yen weakens.

To clearly see the risks, think of it this way: A falling dollar is bad for Toyota’s competitive position, and it results in losses on the currency derivatives held in DXJ.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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