US-based ETF investors are withdrawing en masse from currency-hedged international funds, despite advice to the contrary.
The three largest currency-hedged ETFs in the US have seen combined outflows of around $3.5 billion so far this year as the US dollar has declined more than 9% against rival currencies.
The WisdomTree Europe Hedged Equity Fund (HEDJ), the WisdomTree Japan Hedged Equity Fund (DXJ) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF) also lost $19 billion worth of outflows in 2016, as reported by ETF.com.
A falling greenback makes currency-hedged returns weaker than their unhedged ETF counterparts – at least in the short term.
HEDJ is up 13% since 1 January, compared to more than 23% returns for its unhedged counterpart, the Vanguard FTSE Europe ETF (VGK).
The outflows come despite a recent report from BlackRock which advises investors to choose currency-hedged funds for their international exposure as currency fluctuations tend to even out over the long term.
“These differences between hedged and unhedged returns have historically tended to narrow in the very long run, and investors should not expect to be rewarded for holding currency risk over time,” said the report, adding that holding pure exposure can increase a portfolio’s volatility.
Pure currency exposure leads to volatility
Annualised volatility can even double when it comes to unhedged bond holdings, found BlackRock.
With bond yields at record lows, FX volatility can make returns very weak for fixed income investors. The report advised investors to hedge out developed market sovereign, corporate and high yield international exposures.
The Vanguard International Bond ETF (BNDX) has seen large inflows this year, pushing its total assets to more than $8 billion and making it the second-largest international bond ETF on the market.
Japan and EM are different
The two exceptions to the hedging rule, found the report, are Japan and emerging markets.
Japan’s currency tends to travel in the opposite direction to its stock market, but BlackRock still recommends developed market exposure as an overall asset class should be hedged out.
In EM, “FX exposure and carry (the income from interest rate differentials) are key sources of total return for local-rate portfolios. And hedging is often either impractical or prohibitively expensive”, the report noted.