Currency-Hedged ETFs Still Popular

Generally speaking, most international-equity funds do not hedge their foreign-currency exposure. During the last few years, major foreign currencies such as the yen and euro have been falling against the U.S. dollar, and this has negatively impacted the performance of funds that invest abroad. Currency-hedged exchange-traded funds are relatively new products that provide the returns of foreign-equity markets without the impact of currency fluctuations. So when other currencies are falling against the dollar, currency-hedged ETFs will likely outperform their currency-unhedged peers. Conversely, when foreign currencies rise against the U.S. dollar, a currency-hedged ETF will likely underperform its currency-unhedged peers.

The major currencies tend to move in cycles, so over the long term, these fluctuations tend to net out. As a result, currency-hedged and currency-unhedged portfolios will have very similar returns in periods of 10 years or more. But currency movements are a source of volatility within an international-equity fund, so currency-hedged portfolios are somewhat less volatile relative to their unhedged peers.

It is unlikely the yen and euro will exhibit sharp declines versus the U.S. dollar, as they had during the last few years and which resulted in very strong outperformance by currency-hedged ETFs. Currently, a relatively healthier U.S. economy suggests the U.S. dollar may slowly appreciate against other currencies in the medium term. If this proves true, currency-hedged ETFs will slightly, but not significantly, outperform their unhedged peers. But geographically diversified, currency-hedged ETFs continue to draw strong inflows, perhaps as investors begin to use these products alongside currency-unhedged funds within their international-equity allocation. A decision to include a diversified, currency-hedged ETF as a long-term holding is a reasonable strategy. What we don't recommend is investors using currency-hedged ETFs to make market-timing bets.

Investors should note there is a cost to hedge currencies, but for the euro and yen, this has historically been almost negligible. However, hedging emerging-markets currencies can be very costly. As such, we do not recommend currency-hedged emerging-markets funds.

Below is our report on

Suitability Deutsche X-trackers MSCI EAFE Hedged Equity is for those who want to invest in developed-markets equities (outside of North America) but don't want the impact of changes in the exchange rate between the U.S. dollar and major developed-markets currencies (namely the yen and euro) on the returns of their fund. This fund is an attractive choice during periods when the U.S. dollar is rising against other major currencies. However, DBEF is expected to underperform its currency-unhedged peers during periods when the U.S. dollar falls against other currencies.

Within a diversified stock and bond portfolio, Morningstar advises investors to allocate between 15% and 20% to international equities. Investors can use an index fund like DBEF as one of their holdings within their international-equity allocation.

In theory, over the long term, the returns of a hedged and unhedged portfolio of developed-markets equities should be almost the same. This is because the U.S. dollar and most developed-markets currencies are free-floating currencies, which should adjust to reflect differences in real interest rates between the two countries. However, in the short term, currencies can trend away from their fundamental value, sometimes for many years. As a result, the relative performance of a hedged portfolio versus an unhedged portfolio is very time-specific. But over periods of 10 years or more, the difference in returns is generally within 100 basis points.

For investors based in the United States, a currency-hedged strategy can reduce the volatility of an international-equity portfolio. This may be partly attributable to the fact that the U.S. dollar is considered a safe-haven currency and tends to rise when risk aversion is high. In other words, when volatility spikes in global markets, the performance of an unhedged international-equity fund can be negatively affected by falling international-equity markets as well as a rising U.S. dollar/falling foreign currency. During the 2008 global financial crisis, the unhedged MSCI EAFE Index had a maximum drawdown of 54.2%, whereas the hedged version declined 47.7%. During the past 25 years, the hedged MSCI EAFE Index also exhibited slightly less volatility than the unhedged index. This makes sense, as currency fluctuations are a source of return volatility in an unhedged portfolio.

Fundamental View DBEF is not really comparable to the funds in the foreign large-blend Morningstar Category. This is because most international-equity funds (both actively managed and passively managed funds) do not hedge their foreign-currency exposure. During certain periods, a long exposure to foreign currencies can add to performance. In the seven years through December 2007, a falling U.S. dollar provided a boost to foreign-equity funds. During that time period, the unhedged MSCI EAFE Index outperformed the MSCI EAFE 100% Hedged to USD Index by 400 basis points annualized. As a currency-hedged ETF, this fund would significantly underperform (and receive a lower Morningstar Rating) during periods when the U.S. dollar is falling against major currencies.

More recently, this trend has reversed. With a relatively healthier domestic economy, the U.S. Federal Reserve has indicated it will begin to raise short-term interest rates soon. However, the eurozone and Japan are expected to maintain aggressive monetary easing as the region continues to face recessionary and deflationary pressures. This divergence in central bank policies between the U.S. and the other major developed markets has supported the recent appreciation of the U.S. dollar against major currencies.

During the past few years, central banks in the developed world have been fairly transparent about their monetary policies and their goals, so it hasn't been that difficult to predict the performance of the euro against the U.S. dollar. However, central banks can suddenly change their minds: In January 2015, the Swiss National Bank surprised global markets when it decided to drop its exchange-rate cap, which sent the Swiss franc soaring. As with most asset classes, market-timing currency movements may be a fool's game.

There is a cost to hedging, which can be estimated by calculating the difference in short-term interest rates between the U.S. dollar and a foreign currency. If a foreign currency has a lower short-term rate, this results in a positive carry, because you are borrowing foreign currency at a lower rate and reinvesting in U.S. dollars at a higher rate. Positive carry provides a boost to returns. However, when foreign currencies have higher short-term rates relative to the U.S. dollar, this results in a negative carry. During these periods, hedging will result in a cost. Historically, the cost to hedge the yen and euro has been almost negligible, but that may not always be the case going forward.

This fund uses currency forwards to hedge its foreign-currency exposures. While the use of these derivatives does introduce counterparty risk, this risk is limited, as the contracts cover only the movement of the foreign currency and not the entire value of the fund. There are also tax issues related to these derivatives contracts. Currency-hedged funds must distribute gains on currency forwards to fundholders, which are taxed at a combination of long-term and short-term capital gains rates (60% long-term and 40% short-term). During periods when the U.S. dollar is rising against hedged currencies, the monthly roll of these currency contracts can result in capital gains.

Portfolio Construction This ETF employs full replication to track the MSCI EAFE 100% Hedged to USD Index, which seeks to represent a close approximation of the performance of a hedged exposure to its parent index, the MSCI EAFE Index. The index (and fund) hedges out its foreign-currency exposures by selling forward contracts at the one-month forward rate. The fund rebalances its currency hedge on a monthly basis. The parent index is a float-adjusted, cap-weighted index that includes about 900 companies and accounts for about 85% of the publicly available total market capitalization of the 21 developed markets (as defined by MSCI) outside of North America. The largest country weightings are Japan (23%), the United Kingdom (20%), France (10%), and Switzerland (9%). Its largest currency exposures are the euro (30%), the yen (23%), and the pound sterling (20%). During periods when the major developed-markets currencies fall significantly against the U.S. dollar, the monthly roll of these currency contracts can result in capital gains. Through 2014, Deutsche elected to classify these gains as income, which carries a higher tax liability (income versus capital gains). Starting in 2015, the fund will classify gains from the forward contracts as capital gains.

Fees

The fund's 0.35% expense ratio is low relative to actively managed foreign large-blend funds (which carry a median expense ratio of 1.06%) and a bit higher than the cheapest developed-markets ETF,

Alternatives WisdomTree, iShares, and DB X-trackers each offer a family of currency-hedged ETFs covering different regions of the world. The WisdomTree funds track dividend indexes created by WisdomTree, and iShares and DB X-trackers follow MSCI indexes. These funds all use short-term currency-forward contracts to hedge their foreign-currency exposure.

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