Over the past decade, globalization has led to innovation and
novelty in the fields of cross border trade and investments; they
are no longer limited to the geographical boundaries and
jurisdiction of a particular nation.
While this has opened a door of vast opportunity for individual
investors, fund managers and corporations, in terms of risk return
tradeoff this falls in the high risk high return category which
might not be suitable for everyone. Coupled with lack of
understanding of most financial products, it has led to many
investors getting burned.
International investments and trade are subject to a series of
risk factors which actually involves much more than investing or
carrying out business in one’s own country. While there are a host
of ‘extra’ risk factors that investors have to take care of while
investing outside their respective countries (example geo-political
risk, environmental risk, government regulations etc), one factor
which pretty much stands out from the rest is currency risk (read
Three Currency ETFs Outperforming The Dollar).
This is a recurring phenomenon, as exchange rates are
continuously changing and are functions of macroeconomic factors
such as central bank regulations, interest rates, inflation, fiscal
deficit, and trade deficit. Thus, investors have to keep in mind a
host of other factors (apart from the asset class they have
invested in) before considering international investments.
Basically international investments are subject to 1) Volatility
of the asset class they have invested in, i.e. equity market
volatility for equity investments, credit rating and effective
duration to measure credit and interest rate risk in case of fixed
income investments (see Forget Interest Rate Risk with These Bond
ETFs), and 2) Volatility of the currency in which the invested
assets are denominated (i.e. exchange rate of asset denominated
currency versus the domestic currency).
This is particularly important as negative currency fluctuations
can virtually wipe out the entire returns from investment abroad
even if the asset class has been able to provide the desired rate
of return. In other words, the rate of return for a U.S investor
who has exposure in Brazilian equities (denominated in Brazilian
Real) is 8% which is in alignment to his/her expected returns.
However in that time period if the U.S. dollar appreciates by 6%
against the Brazilian Real, the effective rate of return on the
Brazilian investment will be 2% (8%-6%), wiping out almost all of
the returns. Conversely, if the Brazilian Real appreciates 6%
versus the USD, the rate of return will be 14% (8%+6%) (see more in
the Zacks ETF Center).
Thus we see that currency movements do play a very important
role in determining the return on international investments.
However, for investors seeking a basket approach to international
investments without being subject to the currency risk factor, we
have the Currency Hedged ETFs.
These innovative products provide investors the pure exposure in
foreign assets less currency risk. These currency
hedged ETFs provide exposure to the equity markets of the
countries/broad regions they track at the same time maintaining
U.S. dollar neutrality with the help of currency futures.
Therefore, the investors are only concerned about the core
returns from their investments as the currency risk (against a
probable U.S dollar appreciation) is mitigated (read Is It Time to
Buy the Hedged Currency ETFs?).
Sounds interesting? Maybe it does, but these intriguing products
have been unable to capture the interest of the investors and have
been extremely unpopular. The following table shows various
characteristics of the Currency Hedged ETFs.
Table 1
ETF
|
Country/ Region Exposure
|
Total Assets
|
Average Daily Volume
|
Bid-Ask Spread
|
Expense Ratio
|
Asset Inflow/ (Outflow) Q1-Q3 2012
|
YTD Returns (as of 30th September
2012)
|
DXJ
|
Japan
|
610.86 million
|
177,901
|
0.12%
|
0.48%
|
+$204.66 million
|
0.89%
|
DBBR
|
Brazil
|
4.16 million
|
6,800
|
1.52%
|
0.60%
|
-$0.02 million
|
-10.54%
|
DBCN
|
Canada
|
4.60 million
|
750
|
1.25%
|
0.50%
|
-$0.02 million
|
3.80%
|
DBJP
|
Japan
|
4.76 million
|
5000
|
2.05%
|
0.50%
|
-$0.02 million
|
-0.18%
|
DBEF
|
Europe, Australasia, Far East
|
14.16 million
|
27,000
|
1.92%
|
0.35%
|
-$13.57 million
|
3.62%
|
DBEM
|
Emerging Markets
|
4.47 million
|
7,400
|
7.30%
|
0.65%
|
-$0.02 million
|
-0.95%
|
HEDJ
|
Developed Europe
|
24.82 million
|
10,000
|
0.73%
|
0.58%
|
+$5.17 million
|
6.74%
|
Source: 1) Average Daily Volume and Bid-Ask Spread
from xtf.com,
ii) Asset Fund flow from
indexuniverse.com.
As we can see, apart from DXJ, other ETFs from the currency ETF
space have been clearly lagging behind in terms of total assets and
total traded volume.
In fact, the extremely thin average daily volume of these ETFs
have primarily caused their market prices to remain stagnant over
time even if the per unit value of the underlying basket of
securities i.e. Net asset value (NAV) have moved significantly.
This has caused many of them to post significantly lower market
price returns than their NAV returns and the Index Returns.
For example, the market price returns for db-X MSCI
Brazil Currency Hedged Equity ETF
(DBBR) for one year
ending as of 30th September 2012 is -10.54%, however,
for the same time period the NAV returns and the index i.e. The
MSCI Brazil US Dollar Hedged Index returns are
-2.04% and 1.56% respectively.
Similarly, for the db-X MSCI Emerging Markets Currency
Hedged Equity ETF (DBEM)
the difference between market price returns and the NAV/Index
returns is quite significant. For the same time period the NAV and
Index i.e. MSCI EM US Dollar Hedged Index returned
4.92% and 8.71% respectively compared to its market price returns
of -0.95% (read France’s Credit Downgrade: How Does it Impact the
French ETF?).
Also, the paltry asset base for most of the currency hedged ETFs
coupled with lower traded volume gives rise to high bid-ask spreads
that in turn can lead to higher costs for investment in these
products.
Another consideration is that the fund flow data from these ETFs
have been on the negative side for most of these ETFs so far this
fiscal year indicating almost no appetite for these ETFs.
This is especially surprising as the macroeconomic factors were
favorable for the same ETFs, primarily thanks to a strong dollar
which has been one of the strongest currencies so far this year,
serving as the safe haven currency for investors in these volatile
times (read Volatility ETFs: Three Factors Investors Must
Know).
Therefore, technically these ETFs should have gained in terms of
asset base as investors seeking exposure in foreign currency
denominated assets seek to minimize the impact of the rising
dollar.
However, having said this it is prudent to note that the
WisdomTree Japan Hedged Equity ETF
(DXJ) stands out
handsomely ahead of the rest of the pack having amassed an inflow
of $204.66 million in its asset base suggesting that this is pretty
much the only ETF from this space that has been able to grab
investor attention.
While it is difficult to ascertain the exact reason for lack of
popularity for these products, it is pretty certain that Currency
Hedged ETFs surely are decent choices and cost effective tools to
minimize currency risk for investors seeking international
exposure.
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DB-X MS BRZ CUR (DBBR): ETF Research Reports
DB-X MS CDA CUR (DBCN): ETF Research Reports
DB-X MS EAF CUR (DBEF): ETF Research Reports
DB-X MS EMG MKT (DBEM): ETF Research Reports
DB-X MS JPN CUR (DBJP): ETF Research Reports
WISDMTR-J HEF (DXJ): ETF Research Reports
WISDMTR-I HE FD (HEDJ): ETF Research Reports
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