How Currency-Hedged ETFs Work

If there’s an investment objective you can think of, then you can almost guarantee that some investment management company has designed an exchange-traded fund (ETF) to fit that objective. There are ETFs that specialize in leveraged real estate or in junk bonds. Others are there to limit investors’ exposure to currency exchange rates. And with scores of independently trading currencies in existence around the world, there’s probably a currency-hedged ETF for you.

Foreign Exchange, Domestic Dealings

Take BlackRock Inc.’s (BLK) iShares, which assembles and maintains over 330 ETFs – one of the largest rosters in the industry. Those funds include several currency-hedged ones, each denominated in a particular currency (or basket) and packaged to American investors, or at least to investors who normally transact in U.S. dollars. (For more, see: Blackrock’s iShares ETFs.)

But why would an investor hedge ETF investments? Aren’t ETFs broad enough to avoid uniformity in the first place? ETFs offer diversification, but a standard ETF that invests in foreign markets won’t do a thing to protect you against currency fluctuations. Currency-hedged ETFs protect you against exchange rate hits. Or, if you’re a glass-half-full kind of person, help you take advantage of potential gains in other currencies vis-à-vis the U.S. dollar. A strong dollar can hurt your international exposure, as it takes correspondingly more Swiss francs or Norwegian kroner to equal the purchasing power of a greenback. The U.S. dollar has indeed strengthened against a basket of heavily circulated currencies throughout much of 2015, enough to make currency-hedged ETFs that much more attractive to investors.

Never Worry About Hyperinflation Again

The concept is simple. In some cases, a currency-hedged ETF can be nothing more than an existing ETF – same components, same proportions, same expense ratio – but denominated in something other than U.S. dollars. The fundamental difference is that the currency-hedged ETF contains positions in currency forwards, which are essentially futures contracts on currencies. Forwards allow you to lock in the price of a currency today, regardless of eventual fluctuations. Currency forwards don’t fit the strict definition of futures contracts, because they don’t trade on exchanges. (For more, see: Derivatives – Fundamental Differences Between Futures and Forwards.)

Hedge a Little or a Lot

Generalizing, currency-hedged ETFs come in two varieties: single-currency and multiple-currency. Single-currency-hedged ETFs are the more common of the two.

Take iShares’ MSCI Japan ETF (EWJ), for instance. The unhedged ETF returned 11% over a recent 16-month period. Its hedged cousin returned 30%. Not coincidentally, the U.S. dollar gained 14% versus the yen over that same period. In retrospect, if you had to buy one or the other, the hedged fund seems like the obvious choice. Japan was suffering from deflation at the time, at a level even more pronounced than that in the United States. Macroeconomic policy indirectly led to the devaluing of the yen, and here we are. (For more, see: Top Japan ETFs.)

If one firm’s yen-denominated hedged ETF outpaces its non-hedged counterpart, it’s reasonable to assume that other yen-denominated ETFs will, too. Take WisdomTree Investment Inc.’s (WETF) Japan-hedged equity fund (DXJ). Its holdings are your standard Japanese multinationals: Toyota (TM), Mitsubishi UFJ Financial (MTU), etc. Over the past year, the fund’s net asset value (NAV) has increased 10%. If you’d invested in a non-hedged fund of similar constitution, you’d be down 5% thanks to a pummeled yen.

As for multiple-currency-hedging ETFs, in practice they focus either on a particular region (e.g. Europe, emerging markets), or a certain size of company (e.g. small-cap). Should the involved currencies fall enough against the U.S. dollar, the composition of the funds becomes less important. In fact, if the appropriate currencies are in play, a small-cap non-hedged ETF assembled by an adept manager can end up being worth considerably less to your portfolio than can a currency-hedged ETF of ordinary composition. (For more, see: Invest in Japan with this ETF.)

The Bottom Line

You’re not going to get rich off predicting movements between and among currencies. Well, you could, but you’d have to start off with an awfully large leveraged bankroll. On the other hand, if you are looking at currency-hedged ETFs as a way to stave off real-dollar losses, these days investment firms are going out of their way to accommodate you.

The upsurge in currency-hedged ETFs is a recent phenomenon spurred by an unmistakable cause – national banking authorities obsessed with inexpensive money. Players are entering the market at an alarming rate, with Aegon (AEG) subsidiary ProShares among the latest to offer a suite of currency-hedged ETFs, both single and multiple-currency. With more such ETFs available to the individual investor, and firms thus forced to compete on price (which is to say, expense ratios), there’s never been a better time to not only expose yourself to international markets, but reduce price movement risks while doing so. (For more, see: ETF Plays for a Surging Greenback.)