Brexit Kicked Currency-Hedged ETFs into High Gear

The Brexit vote in June sent United Kingdom stocks on a wild ride, and currency-hedged U.K. exchange traded funds have been a clear winner in the aftermath.

Since the June 23 close, the day prior to the watershed United Kingdom referendum vote on European Union membership, currency-hedged U.K. ETFs have rebounded from their initial knee-jerk sell-off, and then some. The iShares Currency Hedged MSCI United Kingdom ETF (NYSE:EWU) gained 7.2%, WisdomTree United Kingdom Hedged Equity Fund (Nasdaq:DXPS) rose 11.1% and Deutsche X-Trackers MSCI United Kingdom Hedged Equity ETF (NYSE:DBUK) increased 9.1%.

The benchmark FTSE 100 Index has also returned 9.1% since June 23.

Meanwhile, the iShares MSCI United Kingdom ETF (NYSE:EWU), a non-currency-hedged U.K. ETF, fell 4.9% since the June 23 close.

The divergence between the currency-hedged and non-currency-hedged ETFs reveals that U.S. investors seeking international exposure face significant risks to fluctuating foreign exchanges. For instance, the CurrencyShares British Pound Sterling Trust (NYSE:FXB) plunged 13.3% as the pound depreciated to $1.2909 from $1.4877 since June 23.

“Currency risk can impact international equity return and risk, but full exposure is often assumed to be the neutral position with asset allocation decisions,” Deutsche Asset Management strategists said in a recent a research note. “Examining the role of currency risk from a long-term asset allocation standpoint finds that currencies can add risk to international equities without improving returns. Reducing currency risk exposure can potentially improve long-term portfolio outcomes, and may be considered the ‘new neutral’ for portfolios.”

For example, in the case of United Kingdom exposure, investors may have found a more "neutral" position with currency-hedged ETFs as the smart-beta strategies have more-or-less reflected the same performance of the underlying U.K. assets, and even the FTSE 100, sans currency risks.

However, potential investors should keep in mind that these currency-hedged ETFs may underperform non-hedged strategies when a foreign currency appreciates against the U.S. dollar, so the investment strategy is not without its risks.

For now, the currency-hedged U.K. ETFs may continue to outperform their non-hedged counterpart, especially with the Bank of England now supporting more aggressive monetary policies and accommodative measures to support the economy in a post-Brexit environment, which will put further pressure on the British pound.

Last week, the Brexit spurred the BOE's first interest-rate cut in seven years and pushed officials to raise their gilt-purchase program by 60 billion pounds, or $78 billion, to 435 billion pounds and extended the program to included corporate debt.

Investors and market watchers are also keeping an eye on the government to implement any fiscal stimulus measures as well.

Moreover, a weakening GBP will continue to benefit British exporters and the large-cap segment, which has been reflected in the rebound in the FTSE 100.

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