Portfolio Building With Currency-Hedged ETFs

Several years ago, currency-hedged exchange-traded funds were viewed as niche concepts. These days, ETFs that provide equity exposure while profiting from the dollar's strength against currencies ranging from the euro to the yen and many more are mainstream.

Led by the WisdomTree Inter Hedged Eq Fund (NYSE:HEDJ) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBX ETF Trust (NYSE:DBEF)), currency-hedged ETFs are among this year's most prolific asset gatherers, extending the rapid growth of this ETF genre. Year-to-date, HEDJ and DBEF are the top two asset-gathering ETFs with combined inflows of over $27.5 billion.

Those figures suggest advisors and investors are embracing currency-hedged ETFs at a fevered pace. Staggering growth for HEDJ, DBEF and other currency-hedged ETFs confirm that these funds can in fact be cornerstones of well-diversified portfolios.

Currency-Hedged ETFs

Currency-hedged ETFs use currency forwards to hedge their foreign-currency exposure, and this cost to hedge can be roughly estimated as the difference in short-term rates between the U.S. dollar and a foreign currency. During the last five years, the cost to hedge (by using forwards) has been very small, averaging about 10 basis points a year, according to a recent Morningstar note.

DBEF follows the MSCI EAFE US Dollar Hedged Index. Importantly, DBEF has been superior on a risk-adjusted basis as well.

Diverging developed market monetary policies increase DBEF's allure. Some investors are still betting the Fed will again raise interest rates in the coming months, perhaps as soon as this month. Conversely, the Bank of Japan and the European Central Bank are seen as having the room to add to their already massive easing programs. Combined, Japan and the eurozone account for over 45 percent of DBEF's geographic weight.

Other Currency-Hedged Funds To Watch

DBEF has easily outpaced traditional EAFE funds this year. In addition to HEDJ and DBEF, some other currency hedged ETFs could shine next year as developed market monetary policies continue diverging. If the Bank of England moves to pare rates, the Deutsche X-Trackers MSCI United Kingdom Hedged Equity ETF (DBX ETF Trust (NYSE: DBUK)) and the WisdomTree United Kingdom Hedged Equity Fund (WisdomTree Trust (NASDAQ:DXPS)) could shine.

Previously, currency traders believed the Bank of England would be one of the first developed market central banks after the Federal Reserve to raise interest rates, but wagers to that effect have dwindled. Now, with the Fed poised to raise rates and the Bank of England on hold, calling for further pound weakness is not a stretch. However, that does not mean DBUK and DXPS are sure things heading into 2016.

The Complicated Nature Of Hedging

Currency-hedged ETFs use currency forwards to hedge their foreign-currency exposures, and there are tax issues related to these derivatives contracts. Currency-hedged funds must distribute to fundholders the gains on currency forwards, which are taxed at a combination of long-term and short-term capital gains rates (60 percent long-term and 40 percent 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, added Morningstar.

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