By DAISY MAXEY
May 6, 2016 5:30 a.m. ET
The U.S. dollar’s weakness this year has shown the downside of hedging currency exposure when investing in overseas stocks.
Investors are taking note, pulling money out of currency-hedged exchange-traded funds after heavy buying last year, as the funds proliferated.
The rush of money into the hedged funds—and the recent movement out—is evidence that investors were chasing performance, says Ben Johnson, director of global ETF research at Morningstar Inc.
Investors “have a near-zero chance of regularly and effectively timing currency movements,” Mr. Johnson says.
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A number of factors can influence foreign-exchange rates, among them central-bank policies, including changes to interest rates, as well as a country’s inflation rate, economic performance and political stability.
Until recent years, most U.S. mutual funds and ETFs that bought overseas stocks didn’t take steps to reduce the effects of currency fluctuations. In any given period, changing exchange rates could either boost or reduce a U.S. investor’s return compared with the return on the funds’ holdings in local currencies.
Hedging was more expensive years ago, and some managers didn’t believe that hedging currencies was worth the cost. Some still don’t as they expect currency fluctuations to net out over time.
When the U.S. dollar strengthens against a foreign currency, a U.S. investor will get fewer dollars when converting holdings denominated in that currency back to U.S. dollars. That is, unless the investment was hedged.
Currency-hedging funds generally negate the impact of currency movements via forward contracts, which allow buyers to purchase a currency at a set price at some future date.
Consider last year, when the WSJ Dollar Index, which measures the greenback’s strength against a basket of 16 currencies, rose 8.6%. The MSCI EAFE index of stocks in developed overseas markets rose 2.7% in local currencies, but fell 3.3% in dollar terms in 2015.
By contrast, this year through Wednesday, the WSJ Dollar Index is down 5%, and hedging has hurt performance. The MSCI EAFE index is down 8.7% in local currencies but only down 4% for a U.S.-dollar investor, because the decline in the stocks was partially offset by a gain on the overseas currencies.
The outflows from currency-hedged ETFs tracked by Morningstar began in September. After taking in nearly $41.8 billion from January through August of 2015, the funds experienced net outflows of $1.8 billion from September through December. Nearly $6.5 billion more flowed out in the first three months of this year, says Morningstar, which currently tracks 48 currency-hedged ETFs.
There is an argument to be made for consistently hedging currency exposure—to focus on the returns of the underlying securities—and one for accepting currency risk as another variable in a diversified portfolio. But shifting between hedged and unhedged investments is essentially another variation of market timing and tough to do successfully.
“People are chasing the performance of the U.S. dollar,” says Paul Bosse, a principal in the Vanguard Group’s investment strategy group. “Is that really a surprise? We’ve seen those sorts of chasings go throughout the years.”
He says the decision to hedge currency exposure should be “a long-term position; it’s not an on/off switch.”
Some advisers who moved into hedged international-stock funds in recent years sold as they became less bullish on international shares in general.
For example, Jeffrey Carbone, co-founder and senior partner at Cornerstone Financial Partners Inc. in Huntersville, N.C., began investing in a dollar-hedged European-stock ETF in December 2014. But seeing slow global growth and anticipating a weaker dollar, he sold a portion of that position last year and the remainder in January. Mr. Carbone says his portfolio is now overweight in U.S. stocks and underweight in international equities.
Hardest hit by outflows this year among the currency-hedged ETFs Morningstar tracks are several from WisdomTree Investments Inc. which were very popular with investors in 2015. These include WisdomTree United Kingdom Hedged Equity Fund, with net outflows of $4.5 billion this year through March, according to Morningstar; WisdomTree Japan Hedged Equity Fund, with outflows of $3.1 billion; and WisdomTree Europe Hedged Equity Fund, which saw $2.5 billion withdrawn.
Investors are using different foreign-stock ETFs in different ways, says Luciano Siracusano, chief investment strategist at WisdomTree, whose offerings include 23 currency-hedged stock ETFs and 31 foreign-stock ETFs that don’t hedge. When U.S. investors think about broad overseas exposure, many are using a hedging approach as part of a permanent allocation, so they don’t have to worry about fluctuations in exchange rates, he says.
But investors appear to be more tactical about investing in funds focused on Japan, Mr. Siracusano says.
In general, the Japanese stock market does well when the yen is weakening against the U.S. dollar, and badly when the yen is strengthening, he says. The latter has been the case so far this year—the Nikkei 225 Index is down 15.2% year-to-date—and in the first quarter, money exited both hedged and unhedged Japanese-stock ETFs tracked by Morningstar.
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