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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Tickers in this Article: DXJ, DBBR, DBJP, DBEF, DBEM, HEDJ

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