Clipped: The downside of funds that "hedge" currencies

AP News
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Posted: Mar 24, 2016 2:23 PM
Clipped: The downside of funds that "hedge" currencies

NEW YORK (AP) — It seemed like a can't-miss idea at the time.

Investors scrambled last year to get into a new breed of exchange-traded funds, ones that own foreign stocks and use complicated trading strategies to insulate investors from the swings created by changing currency values. But a year after this new style of ETFs drew billions of dollars and become one of the hottest trends in investing, some investors are now leaving after seeing the strategy's downside — and locking in losses.

It's too early to tell if the trend working against what the industry calls currency-hedged ETFs will last, or if the exit by some will continue. But investing has many examples of people picking up on a winning trend, catching it late and jumping out at the first sign of struggles.

"It looks like the majority of flows into currency-hedged ETFs came in too late," says Alina Lamy, senior analyst at Morningstar. "Currency hedging is maybe a good idea, but if they're too late, the benefit is not as pronounced."

The benefit was obvious in late 2014 and early 2015, when foreign stocks were rising, but their value in dollars was being undercut by weakening foreign currencies. European stocks returned 7.4 percent in euro terms during 2014, for example, as measured by the MSCI Europe index. But each of those euros was worth fewer dollars, so the average European stock mutual fund lost 7.3 percent in dollar terms that year.

The fix: currency-hedged ETFs. Like other ETFs, these funds track indexes. But the indexes they track follow foreign stocks in their local currencies and try to "hedge out" the effect of their shifting values against the dollar. The WisdomTree Europe Hedged Equity fund used that strategy to return 4.7 percent in 2014, when many traditional, "unhedged" European stock funds lost money, for example.

The strong performance for currency-hedged funds in late 2014 and early 2015 led to an explosion of demand for them. The industry rolled out more and more as dollars kept pouring in, and Morningstar counted 59 currency-hedged ETFs at the end of 2015, double the number from a year earlier.

Total dollars invested in the funds nearly quintupled in the span of just 12 months, leaping to $67.8 billion in July 2015, from $13.9 billion a year earlier.

Too bad much of that investment came just as the dollar's value was topping out against other currencies.

Foreign stocks had been rising on expectations that the European Central Bank, Bank of Japan and other central banks would cut interest rates and expand programs to stimulate their economies. At the same time, the values of the euro, yen and other currencies were falling because of those same expectations.

Then the dollar's rise petered out, and caught hedged ETF investors in a bind. Foreign central banks behaved as expected, but the U.S. Federal Reserve reiterated that it would be slow in raising interest rates, which weakened the dollar.

The dollar reached a peak against the euro last March and is down nearly 3 percent this year. The dollar is down even more, nearly 7 percent, against the Japanese yen over the same time.

The halt in the dollar's rise means unhedged foreign-stock funds once again are at the advantage. Traditional Japanese stock mutual funds have lost an average 3.7 percent, this year, a milder loss than the 12.9 loss for the largest currency-hedged Japanese stock ETF.

The change in momentum means some investors have already started to pull away from currency-hedged funds. Investors withdrew a net $1.2 billion from the WisdomTree Japan Hedged Equity ETF during February, for example. Only four other stock mutual funds or ETFs saw more money leave.

It's too early to say whether this is the beginning of a larger trend away from currency-hedged funds. And, of course, currency-hedged ETFs would take the lead again over unhedged rivals if the dollar resumes its rise. Currency values are notoriously difficult to predict, and the dollar could easily turn back higher if the Federal Reserve continues raising interest rates while other central banks head in the opposite direction.

Some investors also don't mind seeing their currency-hedged ETFs lagging behind unhedged funds. They prefer the simplicity of owning funds that simply track foreign stocks in their own currencies, without having to worry about where the dollar is heading against the euro or yen.

Besides, many analysts say that changes in currency values eventually wash out over the long run. There will be periods in the short term where the dollar shoots higher, but those are often followed by periods of dollar weakness. Over the last decade, the dollar was at one point down as much as 35 percent against the yen. But it's trimmed the loss since then and is now down about 4 percent for the decade.

So, for a long-term investor who's willing to hold onto their foreign-stock funds through their inevitable bouts of volatility, finding a fund that hedges currencies or not may be a less important decision than finding one with low expenses.