by Daniel Putnam | May 22, 2013 12:40 pm
Wall Street is seeing a surge in popularity among international funds that hedge against the impact of foreign currency movements. However, while the recent returns for certain funds are impressive, investors should question whether the outperformance of these products is sustainable given the minimal long-term benefit that hedging has provided.
The poster child of the hedged ETF wave is, of course, the WisdomTree Japan Hedged Equity Fund (DXJ). The fund has returned 67.4% since Nov. 15, as Japan’s money printing policies have simultaneously boosted its stock market and led to a collapse in the value of the yen, as gauged by the -21% return of the CurrencyShares Japanese Yen Trust (FXY).
The unhedged iShares MSCI Japan Index Fund (EWJ) has returned 39.2% in that same interval, and investors have taken note of this 28 percentage-point disparity: Since the start of the year, DXJ has hauled in over $7.5 billion in new assets and received more inflows than any other ETF in the U.S. market.
The disparity between DXJ and EWJ obscures the fact that for the first six-plus years of its history, DXJ didn’t provide superior returns. From its inception on June 6, 2006, through Nov. 15, 2012, DXJ generated an average annual total return of -4.68%, which was only marginally better than the -5.3% put up by EWJ.
Further, WisdomTree reports on its website that in the 10 years through March 31, the yen appreciated 2.3% against the dollar — meaning the fund would have underperformed an unhedged product during that time.
This illustrates a larger point: Even though currency movements can lead to short-term volatility and huge return disparities — such as the DXJ-EWJ divergence we are seeing right now — developed-market currency performance tends to be a wash over time.
In a 2010 piece somewhat deceptively titled “How Hedging Can Substantially Reduce Foreign Stock Currency Risk,” asset manager Tweedy, Browne states:
“We believe that studies and our own experience have generally shown that over long measurement periods, the returns of hedged portfolios have been similar to the returns of portfolios that have not been hedged.”
The paper cites multiple studies that support this. From 1975 through 1988, the average annual return of stocks in Germany, France, Canada, the United Kingdom, Japan and Switzerland were 16.4% on a hedged basis, and 16.5% on an unhedged basis. Regarding a second notable study, the manager wrote, “During our own more recent experience as a global portfolio manager, over the 15¾-year period from January 1, 1994 through September 30, 2009, the MSCI World Index (Hedged to US$) had an annualized return of 5.7%; this return was nearly the same as the return over the same period for the unhedged MSCI World Index, which had an annualized return of 5.8%.”
The paper also points out that the primary benefit of hedging is that it reduces the short-term volatility caused by currency fluctuations. “Over shorter periods of time,” the authors note, “hedged equity portfolios have been significantly less volatile than unhedged equity portfolios, and have avoided heart-stopping, multi-year 45% – 58% currency losses.” This is certainly a benefit, but one that’s less impressive than the massive outperformance that those shoveling cash into DXJ might be anticipating.
One reason that currency performance is unlikely to remain an unimportant driver of long-term performance is that all of the major world economies are experiencing similar challenges. While the U.S. dollar faces the long-term headwinds of rampant central bank money-printing, slow economic growth, poor fiscal management and low bond yields, the exact same can be said for both Europe and Japan, and to some extent, the United Kingdom.
This sortable table on global debt-to-GDP ratios, published by The Wall Street Journal, is instructive. Ordering the world’s nations by 2013 debt-to-GDP ratio reveals that the countries in the worst shape are almost entirely developed-market economies, with Japan at the top, the United States and U.K. at Nos. 5 and 11, respectively, and the rest of the top 20 dominated by euro-bloc countries.
With that in mind, it’s unlikely that any single currency will deliver the type of sustainable outperformance that would create a substantial long-term advantage for either an hedged or unhedged approach.
Individual investors therefore need to be aware that the seemingly endless supply of local currency products being ushered to market is primarily a way for fund companies to sell a “new” asset class rather than a reflection of superior long-term performance potential. A possible sign of the times is that WisdomTree and Deutsche Bank (DB) have been in a race to be the first to issue a euro-hedged fund that invests in German stocks.
This type of feeding frenzy — and the massive flow of assets pouring into DXJ and similar funds — should cause investors to raise an eyebrow and question whether there’s a real investment case here, or if this is just the most recent fad.
If the longer-term performance numbers are any indication, there’s no need to join the herd on local-currency funds.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
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