The dollar is surging, but these ETFs can stop it from taking a bite out of your portfolio

Published Fri, Apr 29 20221:38 PM EDTUpdated Fri, Apr 29 20221:49 PM EDT

The surging U.S. dollar has shown no signs of abating in April, potentially hitting investors who reside stateside but have large exposures overseas. The combination of inflation, supply chain issues and differing actions by central banks has injected uncertainty into some of the world's most prominent currencies. On Wednesday, the Euro slid to a five-year low against the dollar as Russia cut off gas to two of its neighbors. The Japanese yen, meanwhile, has fallen more than 10% against the dollar since the end of February as its central bank tries to keep rates low . On Thursday, the dollar traded at its highest level against the yen since 2002. For U.S. based investors who hold international stocks, the strengthening dollar can make the recent slide for global equities even worse, as the prices of those stocks are falling even faster in dollar terms than in local currencies. Further, with the Federal Reserve signaling aggressive rate hikes in the months ahead, the dollar's strength is likely to hold for at least a little while. "Higher interest rates in one country increase demand for that country's currency and drive that currency higher," said Lauren Goodwin, an economist and director of portfolio strategy at New York Life Investments. "And in the case of the U.S. right now, while most countries in the world are experiencing stronger than average inflation, the U.S. is top of the list. Very strong inflationary impulse and a central bank that is expected to tighten substantially even relative to other tightening central banks." The dollar also benefits from flows to safety during periods of global crisis and a rising commodities market, where many of those contracts are priced in dollars, Goodwin said. One way for investors to account for these changes is to invest in currency-hedged ETFs. There are several major funds on the market that effectively combine broad index funds for specific regions or global stocks in general with currency hedging. One of the firms that offers these funds is WisdomTree, which offers fully hedged ETFs and those with dynamic hedging. Jeremy Schwartz, the global chief investment officer at WisdomTree, said that investors are effectively making a bet against the dollar if they invest in international stocks without a hedging component. "You don't have to make that bet. You can just get the exposure to the stocks," Schwartz said. The WisdomTree funds operate by having one-month contracts to sell certain currencies at a set exchange rate for dollars. If the dollar strengthens over that time, the trade makes money, helping to offset the weaker local currency's impact on stocks. Costs One important way that these ETFs differ from regular funds is that they include hedged contracts. In WisdomTree's case, those are in the form of monthly futures contracts. In a vacuum, this can lead to increased costs for the fund – and ultimately the investor – due to transaction fees and rolling costs associated with updating the futures contracts. That can show up in fund fees. For example, the hedged version of WisdomTree's International Quality Dividend Growth Fund has a higher expense ratio than the non-hedged version . "Any currency hedging should be thought of as a toll or fare that routinely comes due (for example, hedging costs have a monthly cadence if portfolio managers use derivatives with a one-month time to maturity)," Vanguard researchers wrote in a 2018 report on the strategy. "Today, most hedging costs amount to a handful of basis points, but keep an eye on the fee for the service: currency hedging in less-liquid currencies (primarily, emerging markets) can become prohibitively expensive or erode any volatility benefit" However, Schwartz said that the current interest rate environment effectively eliminates those costs for some currency strategies. "You're actually paid to hedge the developed world, like Europe and Japan" because of the low or even negative interest rates in those economies, Schwartz said. WisdomTree currently offers hedged ETFs for Japan, Germany, Europe and international stocks broadly. The firm does not have funds targeting countries like Brazil, where higher rates make that trade more costly. Your portfolio Investors who are considering hedging their international holdings do not have go all-in with a fully hedged fund, and often do not. Goodwin said that a 50-50 split of hedged and non-hedged holdings is a common practice. Dynamic hedging funds, like those offered by WisdomTree, can tweak the ratio for investors based on market indicators. WisdomTree's funds were about two-thirds hedged in April, Schwartz said. To be sure, there is also the risk that hedging a portfolio turns out to be the wrong choice. If the foreign currency strengthens against the dollar, the hedging trade could actually hurt returns, since the futures trades will lose money. Since the trades are effectively directional bets, small moves can cause losses even if the dollar remains strong on a historical basis. Additionally, some of the currency-hedged funds are not based on a broadly used market index, so investors should make sure they know what the fund is tracking.

A money changer counts U.S. dollar banknotes at a currency exchange office in Ankara, Turkey November 11, 2021.

Cagla Gurdogan | Reuters

The surging U.S. dollar has shown no signs of abating in April, potentially hitting investors who reside stateside but have large exposures overseas.

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