With over 1,600 exchange-traded funds to choose from, investors can essentially tap into any corner of the investable universe. Perhaps one of the most popular markets has been ETFs that offer exposure to equities outside of the U.S.. Not only do these funds add great diversification benefits, but they are significantly less expensive than mutual fund options [see Sector SPDRs: How These ETFs Have Performed Since Inception].
When it comes to adding global exposure, it is important for investors to realize how currency exposure can seriously impact bottom line returns. Most international equity ETFs effectively establish a long position in the local currency and a short position in the U.S. dollar. When the value of the dollar is declining, that exposure can work in favor of U.S. investors, as exchange rate fluctuations enhance their returns. But when the dollar strengthens, the currency impact can offset gains or exacerbate losses experienced in the underlying stocks.
To mitigate the fluctuations between a given foreign currency (or basket of foreign currencies) and the U.S. dollar, there are several ETF options available that offer currency-hedged exposure to the most popular foreign equity benchmarks. To see how currency fluctuations can impact returns, we take a look how at how several single-country currency-hedged ETFs stack up against their non-hedged counterparts.
Please note that all chart below are based on adjusted monthly closing prices from January 2, 2013 to May 1, 2014.
Japan: DBJP vs. EWJ
Since 2013, the MSCI Japan Hedged Equity Fund (DBJP) has outperformed its non-hedged counterpart – the MSCI Japan ETF (EWJ). Both funds track the same underlying index – the MSCI Japan Index - with DBJP mitigating exposure to fluctuations between the U.S. dollar and the Japanese yen [see ETF Performance Visualizer].
Germany: DBGR vs. EWG
In the case of German equities, U.S. investors that did not hedge actually made out better over the past year or so. With the dollar strengthening against the euro, the Germany ETF (EWG) has outperformed the MSCI Germany Hedged Equity Fund (DBGR) since 2013.
United Kingdom: DBUK vs. EWU
Please note that the returns in the above chart are based on adjusted monthly closing prices from October 1, 2013 to May 1, 2014. In recent months, the U.S. dollar has strengthened against the British Pound, allowing the United Kingdom ETF (EWU) to outperform its hedged counter part, the MSCI United Kingdom Hedged Equity Fund (DBUK) [see Go Global, But Watch Your Currency Exposure].
Brazil: DBBR vs. EWZ
Since 2013, both Brazil equity funds have logged in negative returns. The MSCI Brazil Hedged Equity Fund (DBBR), however, was able to minimize losses and managed to perform better than its non-hedged competitor, the MSCI Brazil Capped ETF (EWZ).
The Bottom Line
Each of the currency-hedged ETFs can be seen as a potential alternative to the existing international ETFs. Investors who are bearish on the U.S. dollar may want to remain unhedged, while those who expect the dollar to perform well against rival currencies will likely want to remain hedged. Choose your strategy careful – as the charts depict above, currency fluctuations can have a significant positive or negative impact on bottom line returns.
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Disclosure: No positions at time of writing.