In­vestors thought hedg­ing for­eign funds was the wise strat­egy. They were wrong.

The Denver Post - - BUSINESS - By Stan Choe

For­eign-stock funds have been some of this year’s big­gest win­ners, but many in­vestors aren’t feel­ing the full ben­e­fit.

When buy­ing a for­eign-stock fund, in­vestors in­creas­ingly have two op­tions: One in­su­lates in­vestors from the swings in re­turns that can be caused by shifts in the dol­lar’s value against the euro, yen and other cur­ren­cies. These are funds that “hedge” against cur­ren­cies, while the other group lets in­vestors feel their full ef­fect.

Com­ing into this year, with Repub­li­cans fully in charge of Wash­ing­ton, ex­pec­ta­tions were for the dol­lar to build on a post-elec­tion rally, lead­ing many in­vestors to see hedg­ing as the wiser strat­egy. That turned out to be wrong. Those who tried to time the mar­ket by switch­ing into cur­rency-hedged funds missed out on some of the best gains so far this year.

Con­sider the Wis­domtree Europe Hedged Eq­uity fund, an ex­change-traded fund that owns An­heuser-busch Inbev, Tele­fon­ica and other Euro­pean stocks. It also in­vests in the fu­tures mar­ket to neu­tral­ize the ef­fects of the euro’s move­ment against the dol­lar.

The fund jumped 6.6 per­cent be­tween Elec­tion Day and the end of 2016, part of a world­wide rally for stocks. And its re­turns tow­ered over Euro­pean stock funds that didn’t hedge against the dol­lar’s moves ver­sus the euro.

That’s be­cause the dol­lar was in the midst of a strong rally, fol­low­ing the big elec­toral win for Don­ald Trump and the Repub­li­cans. The think­ing was that Wash­ing­ton would en­act poli­cies that would lead to stronger U.S. eco­nomic growth and higher in­ter­est rates. The dol­lar jumped more than 10 per­cent against the Ja­panese yen within a cou­ple months of Elec­tion Day, and close to 6 per­cent against the euro.

As a re­sult, each euro was worth fewer dol­lars at the end of the year. So, while Euro­pean stocks rose strongly in euro terms, they had a more lack­lus­ter move for in­vestors count­ing in dol­lars. The ishares MSCI Euro­zone ETF, for ex­am­ple, does not hedge cur­ren­cies, and its gain from Elec­tion Day to the end of the year was only about a quar­ter of the Wis­domtree Europe Hedged Eq­uity fund’s.

The two ETFS track dif­fer­ent in­dexes, so they’ll usu­ally have dif­fer­ing re­turns. But cur­rency-hedged funds gen­er­ally will give the bet­ter re­turns when the dol­lar is as­cend­ing against other cur­ren­cies.

But an un­ex­pected thing hap­pened early this year: The dol­lar re­versed course, as some early leg­isla­tive stum­bles dimmed ex­pec­ta­tions for how much Wash­ing­ton can do for the U.S. econ­omy. Plus, economies in Europe and else­where ap­pear to be ac­cel­er­at­ing, which helped their cur­ren­cies.

Some an­a­lysts had pre­dicted the euro would fall to be worth $1 at some point this year. In­stead, one euro is now worth $1.17. In­vestors in funds that don’t hedge against cur­rency swings are both feel­ing the ben­e­fit of ris­ing for­eign stock mar­kets, and en­joy­ing an added boost pro­vided by the ris­ing euro and other cur­ren­cies.

The un­hedged ishares MSCI Euro­zone ETF is up about 19.5 per­cent for the year, more than dou­ble the 7.6 per­cent gain for the Wis­domtree Europe Hedged Eq­uity fund, for ex­am­ple.

This year’s quick shift shows the dan­ger in try­ing to time any kind of mar­ket. Just like it’s dif­fi­cult to pre­dict when stocks will rise or fall, it can be tough to guess where the dol­lar is head­ing. Any­one who jumped into cur­rency-hedged for­eign stock funds this year, and out of un­hedged ones, in ex­pec­ta­tions of much bet­ter re­turns has been dis­ap­pointed.

It may be eas­ier to pick one way to in­vest in for­eign stocks: ei­ther hedged, un­hedged or even a mix of the two, and stick with it. Over the very long term, re­turns for hedged and un­hedged funds of­ten end up look­ing sim­i­lar be­cause changes in for­eign-cur­rency val­ues tend to wash out, an­a­lysts say.

The ma­jor­ity of for­eign stock funds still don’t hedge against cur­rency moves. And hedg­ing is some­thing that’s more com­mon for Euro­pean or Ja­panese stock funds. Low in­ter­est rates in those coun­tries means it’s cheap to hedge against their cur­ren­cies’ move­ments. But in Brazil, Turkey and other emerg­ing mar­kets, in­ter­est rates are much higher and can make hedg­ing so ex­pen­sive that it’s not worth the cost.

“For emerg­ing mar­kets, you could have a strong opin­ion about the cur­rency, but be com­pletely wrong if it’s too costly to hedge,” said Brian Ja­cob­sen, chief port­fo­lio strate­gist at Wells Fargo Funds Man­age­ment.

In the end, many ex­perts say the first ques­tion for in­vestors choos­ing a for­eign­stock fund should not be whether it hedges cur­ren­cies. What’s more im­por­tant is that it’s well run and has low costs.

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