Trader Talk

Why currency-hedged ETFs are hot

Traders work on the floor of the New York Stock Exchange.
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My colleague Michelle Caruso-Cabrera made some very good points on air today concerning investing overseas: because of enormous moves in currency, buying stocks overseas—including ETFs—can be perilous.

As an example, she notes the German DAX index is up 22 percent this year, but the iShares Germany ETF, which measures the performance of the German equity market, is up only 8 percent in U.S. dollars, thanks to the tremendous drop in the euro (down almost 13 percent against the dollar).

This brings up a very interesting question: why doesn't everyone buy hedged international ETFs when they want international exposure, rather than unhedged ETFs?

There are several reasons:

1) Until recently, it was almost impossible for the average investor to do so. There simply were no ETFs that enabled an investor to hedge out currency. A professional could hedge, of course, but at considerable cost.

Now that more hedged ETF products are becoming available, investors are taking note. In fact, the biggest European ETF is now a hedged product, the WisdomTree International Hedged, which recently surpassed its biggest unhedged rival, the Vanguard European ETF.

Largest European ETFs
(assets under management)
WisdomTree International Hedged: $15.1 billion
Vanguard European: $12 billion

2) There was not a huge demand for such a product because currency moves like we have seen in euro this year (down 5 percent against the dollar) are very rare. Oh sure, maybe if you were investing in Argentina, but not the euro, not the yen. Most years did not involve anywhere near such dramatic moves.

This year, for example, the yen has barely moved against the dollar, so the difference between a hedged Japan ETF and an unhedged Japan ETF is very small:

Japan ETFs this year
Wisdom Tree Japan Hedged: up 12 percent
iShares MSCI Japan: up 11 percent

That was not the case last year, when there was an enormous move in the yen versus the dollar, and investors made the DXJ the hottest ETF in years.

As for the cost for international ETFs, it's true they are a little more expensive than plain-vanilla U.S. ETFs. Typically, you'll pay roughly 0.5 percent for a hedged ETF, and even for many unhedged. One exception is the Vanguard European ETF which charges a low 0.12 percent, but that is Vanguard's specialty.

Still, when you are dealing with moves of 21 percent, as you are with Germany this year, an 0.5 percent fee is not unreasonable. It does take work to keep these hedges accurate.

One final point: because interest rates are relatively flat worldwide, it is not that difficult or costly to hedge. The cost is the overnight interest rate. This would be very difficult to do with, say, Brazil, where interest rates are around 8 percent.

As these products get more assets, it's possible the costs will come down.