Building A Currency Hedging Framework Using ETFs

In a new research report released this week, Dodd Kittsley, head of ETF strategy at Deutsche Asset & Wealth Management, created an in-depth look at the effects of currency hedging.  This joint effort with Abby Woodham, ETF strategist at DWAM, posed that investors with foreign stock exposure had become accustomed to a tailwind from a falling U.S. dollar for years.

Nevertheless, the tide appears to have turned and now future overseas investment decisions must be made with both currency and stock expectations in mind. 

The report noted that “Currency exposure was a significant detractor to the return of international equities in 2014. Over the course of the year, the MSCI EAFE Index returned 5.9% in local currency terms.  However, in U.S. dollar terms the index returned –4.9%, a difference of 10.8 percentage points.”

This awareness has caused an explosion of assets flowing into currency-hedged ETFs such as the WisdomTree Europe Hedged ETF (HEDJ) and Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF).  These funds have gained $11.5 and $6.9 billion in total assets respectively this year.  That ranks in the top two spots for all 2015 ETF inflows. 

When building a currency hedging thesis, the report urges investors to “first establish their view of future currency appreciation or depreciation and the expected impact of hedging currency exposure on overall portfolio volatility.  Whether an investor has a positive or negative outlook for international equities is, of course, the most important portfolio-construction factor.”

Investors that believe in a stronger dollar would be urged to adopt a currency-hedged ETF like DBEF, while those that think the U.S. dollar will turn lower should look at a traditional unhedged fund such as the iShares MSCI EAFE ETF (EFA). 

In addition, the report suggests that investors with a “currency neutral” thesis will be better served in a currency-hedged international ETF as the strategy removes the underlying currency risk from the stock portfolio. 

The underlying fundamentals supporting the recent U.S. dollar strength include central bank easing in Europe and Japan versus the consideration of fiscal policy tightening here in the United States.  In addition, the white paper offered an intriguing look at multi-year cycles of currency trends, which suggest the current move in the PowerShares U.S. Dollar Bullish Index Fund (UUP) may persist.