Monetary divergence drives FX ETF growth

By:
Paul Golden
Published on:

After years of modest growth, currency hedged exchange-traded funds (ETFs) are capitalizing on the travails of the euro and yen.

Demand for currency hedged ETFs is not just driven by currency volatility – US investors are looking overseas for equity returns, given the rally in US stocks from the financial crisis low and in the face of a mature bull market.

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  A number of the largest currency hedged ETFs are registering double-digit returns

Nick Kalivas,
Invesco PowerShares

However, the divergence in monetary policy between the US and the eurozone has highlighted the need to reduce foreign-exchange risk for US investors holding European equities.

Facing the prospect of having the currency drop erode the gain from their equity holdings, investors have been enthusiastically turning to currency hedged products in recent months.

This decision has been vindicated, says Nick Kalivas, senior equity product strategist at Invesco PowerShares, who observes that "a number of the largest currency hedged ETFs are registering double-digit returns".

In the US, currency hedged exchange-traded products saw approximately $13.5 billion of inflows in March alone.

According to Townsend Lansing, head of short and leveraged platform at ETF Securities, the firm’s currency hedged commodity platform has experienced $130 million of flows, growing from $51 million in assets under management in January to $189 million year-to-date.

Viktor Nossek, director of research at WisdomTree Europe, says his firm’s currency hedged ETFs have done well when compared against market cap-weighted ETF equivalents.

"Our Europe Equity UCITS ETF hedged into USD is up 12.4% year-to-date, much better than ETFs that track MSCI Europe, which is up 6.9%," he says.

"Our Japan Equity UCITS ETF hedged into USD is up 18% since the start of the year – MSCI Japan is up 14% in USD terms in the same period – and the German Equity UCITS ETF hedged into GBP has year-to-date performance of 11.6%, beating the DAX (7.6%) in GBP terms over that period."

Timing

Previous studies have suggested a global low-volatility equity portfolio that is currency hedged reduces risk by nearly 40% compared with a cap-weighted unhedged index, with 27% of that reduction coming from currency hedging.

However, when considering the performance of specific funds, timing is everything.

So while a European equities ETF that hedges euro exposure would have performed better than an unhedged European ETF year-to-date, the relative strength in the euro over the past two months means the unhedged fund would have fared better, explains Kevin Chen, chief investment officer at Three Mountain Capital Management.

"It is also important to consider that hedging is not free and that hedged ETF investors are likely to pay a higher fee for the additional service," adds Chen.

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Viktor Nossek,
WisdomTree Europe

Despite these caveats, uncertainty around the outlook for the yen and the euro is compelling investors to look closely at currency hedged ETFs, says WisdomTree’s Nossek, while Simon Klein, head of exchange-traded product distribution and institutional mandates, EMEA and Asia at Deutsche Asset & Wealth Management, refers to demand for certainty around equity exposures.

"Our research shows that currency hedging would often have led to a significant reduction in overall portfolio volatility for a global investor, especially for short- to medium-term holding periods," he says.

"On a year-by-year basis over the last 13 years, the currency effect has outweighed equity-market returns in more than half of those years."

Many investors are looking to currency hedged ETFs because they want assurance that they are taking on a clearly defined exposure – whether that is bond or equity – rather than a combination of equity/bond exposure with a heavy currency exposure component.

ETF Securities’ Lansing says many of the investors he has spoken to have traditionally not been concerned with currency risk, but as volatility increases they are realizing the corresponding risk is moving them further away from their core investment objectives, such as the actual underlying exposure in equities, fixed income or commodities.

"There are others who are simply taking a view on the market," he says. "In addition to using currency hedged exchange-traded products, these investors also look to products that provide direct exposure to currency pairs."

Three Mountain’s Chen says it would be logical for ETF providers to be thinking about hedged ETFs for different equity sectors, for example European consumer stocks.

"In addition, there is less supply in hedged international and emerging-markets fixed income ETFs," he says.

An increasing number of European product providers are rolling out currency hedged ETPs across equities and fixed income, says Lansing, adding: "As in all cases, if there is investor demand for more currency exposures, providers will be there to meet it."