Currency-Hedged ETFs: Know What You Own

Increased volatility in developed market currencies should cause investors to examine the impact that these rapid and material foreign exchange movements can have on international equity allocations.

Fortunately, a new breed of ETFs have emerged that allow investors to isolate their targeted international exposure without having to assume the currency risk associated with investing in local markets. These currency hedged ETFs allow allocators to separate their FX view from their view on local market expected returns.

Take a look at the difference in returns between HEDJ and EZU. Both ETFs provide exposure to large cap equities in the Europe, but HEDJ provides a currency hedge while EZU does not.

Source: etfdb.com

HEDJ has outperformed EZU by almost 7% in the last 3 months, much of which can be explained by the decline in the USD/EUR FX rate. Also, note that while 200 day volatility between the two ETFs is virtually identical, the EZU has been almost 4.5% more volatile than the hedged HEDJ. Removing the FX component of the return can reduce volatility in the short-term, especially when the currency is driving equity valuations.

However, not all of the performance difference can be explained by currency movements alone. In the case of HEDJ, there is also significant variance between the two underlying portfolios. HEDJ does not track its non-hedged counterpart as closely as one might assume.

Morgan Stanley just published a good summary of European currency hedged ETFs along with the ETF that most closely resembles the underlying portfolio exposure. They provide the degree of overlap between the various pairs of ETFs:

Source: Morgan Stanley

As you can see from the above table, HEDJ has only a 45% overlap with EZU. Why?

It turns out that there are other factors at work. Wisdom Tree, the issuer of HEDJ, has additional criteria for a company to be included in the portfolio: companies must generate at least 50% of their revenue outside of Europe, giving HEDJ a heavy export tilt to the companies in the ETF.

With this tilt, HEDJ provides investors an additional way for investors to tailor their exposure. Not only can investors express their view on the movement of the currency, but they can also take a view on the likely impact that the currency move would have on the underlying portfolio companies if it occurred. Companies that have a high percentage of revenues outside the Euro area would benefit from a weaker currency compared to companies that export predominantly to other European countries.

An investor would choose HEDJ if they liked European equity exposure, thought the USD/EUR rate was likely to continue to decline, and felt that the currency decline would act as a nice tail wind to European exporters. That’s pretty specific exposure for an ETF that at first glance may appear to be a “passive large cap European equity” ETF.

The ability to customize international exposure by choosing a currency-hedged ETF instead of a traditional market cap weighted ETF provides investors with yet another tool in their toolbox to isolate a macro view. However, as can be be said about any two ETFs, even if they appear to provide similar exposure, further analysis needs to be performed to truly understand what risks are embedded in the portfolio. Know what you own!