A Strong Dollar Lifts Currency-Hedged Funds. There’s a Better Reason to Own Them.
Currency risk is inherent when owning international funds. When the dollar is strong, like it is now, it weighs on corporate returns because foreign revenue will translate into fewer dollars.
The $268 million
WisdomTree Dynamic Currency Hedged International Equity
ETF (DDWM) is up 9.3% in 2024, and its unhedged cousin, the $570 million
WisdomTree International Equity
ETF (DWM) is up 6.7%. The two funds have a 95% overlap, making them a good pair to judge currency impacts. WisdomTree also offers single-currency hedged ETFs, such as the $5.1 billion
WisdomTree Japan Hedged Equity
(DXJ), which is up 26.6%. Most unhedged Japanese ETFs, like the $16.1 billion
(EWJ), are up 8%.
The strategy is proving popular with investors. Across WisdomTree’s nine currency-hedged funds, year-to-date total inflows are $2.1 billion, nearly double 2023’s inflows, says Jeremy Schwartz, the firm’s global chief investment officer. It was one of the first fund issuers to offer currency-hedged ETFs about 15 years ago and has $10 billion in assets under management in the strategy.
To hedge, issuers generally use currency forward contracts to lock in a predetermined future exchange rate, says Dan Sotiroff, a senior manager research analyst at Morningstar. The issuers enter into the contracts on a monthly basis based on the amount of assets in the fund.
Eliminating the foreign-exchange risk lowers the volatility of international funds for U.S. investors in both stocks and bonds, he says. Over about 10 years, hedging can reduce volatility by about 10% to 15% compared with similar unhedged funds. Most index-based international bond funds are currency-hedged for that reason, he adds.
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Currency-hedged ETFs come with a potential surprise: a tax bill. The process that keeps ETFs tax-efficient doesn’t cover the currency transactions, so profitable hedges will incur capital-gains taxes. To mitigate this, Sotiroff recommends using these ETFs in a tax-advantaged vehicle like an individual retirement account.
Nick Codola, senior portfolio manager at Brinker Capital Investments, has used these funds tactically in the past during times when the dollar is stronger, although he isn’t currently. He prefers owning currency-hedged ETFs where there’s only one currency to consider, such as for Japan or the euro zone, rather than an ETF that covers several countries and several currencies.
“There might be some individual currencies that are doing well and some that are not doing well. That might add a whole other wrinkle,” Codola says.
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Schwartz realizes that many investors use these ETFs tactically, but he notes they are meant for longer-term holdings to get the benefit of reduced volatility.
The funds also increase the dollar exposure in an overall portfolio, since the hedges neutralize the currency risk. But Sotiroff says that shouldn’t skew overall returns much since the underlying holdings still drive most of the performance.
Currency-hedged ETFs have some merit, he says, and concurs with Schwartz they should be a strategic choice. Investors need to remember that when the dollar is weaker, these funds will underperform unhedged foreign ETFs. “There will be periods when it’s at an advantage and disadvantage, and you just have to be willing to stick it out,” he says.
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