Why Hedging Currencies Matter

According to SSGA, investors added $48 billion into currency hedged international equity ETFs in the one-year period ended June 2015, compared to $65 billion unhedged broad and narrowly focused international products.

Indeed, WisdomTree Japan Hedged Equity (DXJ) pulled in $5.6 billion in the 12 months ended June, more than the $4.1 billion gathered by the older and larger unhedged peer iShares MSCI Japan (EWJ). Not that iShares has missed out the currency-hedged trend, with its relatively young iShares Currency Hedged MSCI Japan (HEWJ) pulling in $732 million in new money. Deutsche Asset & Wealth Management has also seen strong $800 million of inflows to its own currency-hedged Japanese product.  

Despite the strong investor interest, the returns in the past year of these ETFs are not the same, due to their different approaches. In the one-year period ended July 25, HEWJ rose 28.9%, modestly ahead of the 26.3% gain for DXJ and significantly ahead of the 6.6% for EWJ. EWJ has actually modestly lagged the 6.8% S&P 500 Index, suggesting that investors would have been better suited focusing more domestically.

As their names suggest, HEWJ and DXJ both hedge the yen on a monthly basis, reducing the negative impact of the recent strength in the U.S. dollar. Meanwhile, EWJ does not involve hedging and provides just exposure to Japanese stocks that have recently risen in value. In the past year, the dollar has climbed 21% compared to the yen, eating into the returns for EWJ shareholders.

Weak Yen Can Eat Into Returns

Meanwhile, the more modest performance difference between HEWJ and DXJ can better be understood with a review of their equity holdings. The WisdomTree product holds companies that derive more than 20% of their revenues from outside of Japan that should benefit as the yen weakens, while iShares products have no such multi-national angle.

As such, the sector exposures of the two are not identical. For example, DXJ has more in information technology (13% of assets to EWJ's 10%) and less in telecom services (1% to 5%). HEWJ has the same exposure as EWJ since they both track MSCI indices.

But last week, New York Life's Index IQ launched three new international equity products that provide a partial currency hedge. The relevant one for this article is IQ 50 Percent Hedged FTSE Japan (HFXJ 20 NR), which provides a static hedge on the yen, rebalanced back every month. While the ETF is too young to have a relevant history, we look to the underlying index it seeks to track FTSE Japan 50% Hedged as a guide.

In the 10-year period ended 2014, the 4.9% cumulative return for the 50% Hedged index was only 102 basis points behind the 100% Hedged index and not the 227 basis point lag for the unhedged version. From a volatility perspective, the 50% Hedged Japan index's ten-year standard deviation of 17 was 13% lower than the fully hedged index.

As you consider the improving Japanese economy, determining whether or not you want to partially or fully hedge is important. Because not all Japanese ETFs are the same.

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