ETF Takes Out Currency Variable

NEW YORK ( TheStreet) -- Companies that sell exchange traded funds occasionally release evolutionary products. That may be the case with the recently listed WisdomTree International Hedged Equity Fund ( HEDJ), which protects against currencies.

When a U.S.-based investor buys a foreign stock or fund, he also is buying the local currency. If that currency rises against the dollar, he gets a boost on returns. An advancing U.S. currency puts a drag on performance. The WisdomTree International Hedged Equity Fund takes that variable out of the equation. That's beneficial, as for most of the past decade, the dollar has weakened.

The WisdomTree International Hedged Equity Fund has the same equity exposure as the WisdomTree DEFA Fund ( DWM). The DEFA Fund is essentially the same as the iShares MSCI EAFE Index Fund ( EFA), with the difference being that the WisdomTree fund is weighted by dividends, and the iShares Fund is weighted by market value. In the hedged fund, there is the hedging of the currency on top of the dividend weighting.

The hedge is accomplished with forward contracts that neutralize the movement of the currency proportionally to the country weights of the equities in the fund. The U.K. is the largest country in the fund, at 20%, so the currency allocation is targeted to be the same. Based on the back-test of the ETF, the difference between hedging and non-hedging can be significant. The average annualized return for the DEFA Fund for three years has been minus 1.81%, 8.03% for five years and 6.78% for 10 years. With currency hedging, those numbers would have been minus 4.51%, 6.26% and 4.55%, respectively. Because the dollar has been falling, the hedged version of the index didn't get that benefit.

So what's a practical purpose for such a fund? WisdomTree President Bruce Lavine says an investor could increase foreign exposure because the risk of the currency is removed. Perhaps so, though the ETF may serve investors who have an opinion on the direction of the dollar and a willingness to quickly switch from hedged to unhedged. That description would seem to apply to institutional investors more so than individual investors.

There are plenty of dollar bulls, and their argument usually focuses on things like signs of an economic recovery, interest rates that are likely to rise, other countries being worse off than the U.S., a rally in the greenback or any combination of the four. As late 2008 and early 2009 showed, the dollar is capable of big rallies even when the fundamentals appear to be lousy. Just as this has happened before, it will happen again, and when it does, U.S. investors holding foreign stocks and commodities will get hit hard. The WisdomTree International Hedged Equity Fund offers a way to avoid that, but it's worth repeating that it's a double-edged sword. If the dollar continues on some sort of slow decline, the ETF will lag behind.
At the time of publication, Roger Nusbaum had no positions in the securities mentioned.

Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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