The Currency-Hedged ETF Love Affair Continues

The Federal Reserve did not do U.S. dollar bulls any favors earlier this month when the central bank passed on raising interest rates, but investors should not be hasty in writing obituaries for currency-hedged funds.

Led by the WisdomTree Europe Hedged Equity Fund (NYSE:HEDJ) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSE:DBEF), currency-hedged ETFs have been gathering assets at breakneck speed this year. Year-to-date, HEDJ and DBEF have added $15.5 billion and nearly $13.1 billion, respectively, in new assets.

Predictably, the asset-gathering proficiency of those ETFs and others has been a magnet for critics and scare tactics. Intrepid investors and money managers are ignoring those clarion calls as highlighted by the more than $2 billion in assets added by DBEF in the current quarter. That makes DBEF, the currency-hedged answer to the widely followed MSCI EAFE Index, this quarter's top asset-gathering ETF. Only three ETFs have added more new assets since the start of July than DBEF.

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, according to arecent Morningstar research piece.

While the recent bout of dollar weakness has weighed on DBEF, the fund is down just 0.6 percent this year compared to a 4 percent loss for the MSCI EAFE Index.

Recently slowing momentum for currency-hedged ETFs does not mean investors should abandon the asset class altogether. In fact, some market observers see opportunity with some of these funds, even as some professional investors get skittish about the dollar rally.

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, according to Morningstar.

Japanese stocks are DBEF's largest geographic weight at 21.8 percent while Eurozone nations combine for about a quarter of the ETF's weight. That is to say those long DBEF should be rooting for the Federal Reserve to raise rates while cheering for the Bank of Japan and the European Central Bank to continue to be aggressive in their easing efforts.

A potential wild card for DBEF is the Bank of England, which could raise interest rates sometime in the next year. British stocks are DBEF's second-largest weight at almost 20.6 percent.