Think of it this way: if you have a positive view of the underlying market equities in a foreign country, and a weak view of the U.S. dollar (i.e. appreciating local currency), you could select an unhedged currency investment, which most international equity ETFs currently offer. On the other hand, if you have a positive view of underlying market equities in a foreign country, and a strong view of the U.S. dollar (i.e. depreciating local currency), you could select a currency hedged product.
When the U.S. dollar appreciates, gains on international equity investments can diminish when converted back into U.S. dollars. This is especially relevant right now, as we expect the dollar to strengthen this year. In a stronger U.S. dollar environment, hedged investments tend to outperform.
Market Realist – With weak local currencies and a strong U.S. dollar, hedged investments abroad (EFA) tend to outperform. An example is the performance of hedged investment exchange-traded funds (or ETFs) in Japan in the last few months. In 2012, Japanese Prime Minister Shinzo Abe initiated a massive economic stimulus program, Abenomics, to reverse the country’s chronic deflationary environment and resolve macroeconomic problems. As a result, Japanese stocks enjoyed a 57% (JPY) increase in 2013. However, the Yen also depreciated significantly against the U.S. dollar which detracted from unhedged returns. U.S. investors without hedge protection would have only returned 27% on the year. The following chart compares the performance of the iShares MSCI Japan ETF (EWJ) and the Wisdom Tree Japan Hedged Equity Fund (DXJ). The hedged fund has done well in the weak Yen and strong U.S. dollar (UUP) environment. It has given a three-year return of 46.66%. The iShares MSCI Japan ETF (EWJ) has given a return of 19.8% during the same period.
Read on to find out the things to keep in mind while hedging currencies.