One Way to Play Currency Cycles

NEW YORK (TheStreet) -- After many years of outperformance, foreign and emerging-market stocks have lagged behind domestic stocks for the last couple of years.

Meanwhile, in this era of competitive currency devaluations among central banks, the U.S. dollar has done well. Year to date, the PowerShares DB US Dollar Index Bullish ETF ( UUP) is up 3.4%, and foreign stocks, both emerging and developed, have done poorly compared to the S&P 500.

In the last couple of years, exchange-traded fund providers have created currency-hedged ETFs which can be thought of as middle ground between foreign and domestic. The two leaders in this segment are WisdomTree and db X-trackers.

One top-down reason to buy into a country is because of perceived favorable currency trends. Investors get an extra kick when they choose the right foreign stock and the currency goes up against the dollar. But the right stock and a falling currency can be a drag on returns

A look at the WisdomTree Japan Hedged Equity Fund ( DXJ) can help dissect this a little further. The fund has been successful and has attracted almost $10 billion in assets.

From the start of the year through to the May 22 high, the benchmark Nikkei 225 Index was up 46%, but the iShares MSCI Japan ETF ( EWJ) was up only 24%. The reason was that the Japanese yen as measured by the Japanese Yen Currency Shares ( FXY) went down 15% at the same time.

DXJ, on the other hand, captured most of the Nikkei's rally by going up 42% because the currency fluctuation was stripped out.

The currency hedge is achieved by managing a series of yen derivatives with the stated intention of neutralizing the currency fluctuation. The equity component of DXJ is a dividend-weighted large-cap index. DXJ reports a distribution yield of 2.17% and an expense ratio of 0.48%.

That yield might not seem very high for a dividend-weighted index, but unlike stocks in many other foreign countries, Japanese stocks typically are not high yields, and DXJ's yield is higher than the 1.73% for EWJ.

db X-trackers has a competing fund with the db X-trackers MSCI Japan Hedged Equity Fund ( DBJP), which was actually up 44% in the same time period. The reason for this is that the dividend-weighted index lagged behind the market cap-weighted index, which makes sense for such a big, fast move higher. The safety offered by dividends usually takes a back seat during huge rallies like Japan enjoyed earlier in the year.

Between WisdomTree and the db X-trackers, there are currency-hedged funds for Brazil and broad emerging markets and new funds covering Germany, the U.K. and small-cap Japan.

Of the funds with track records going back to at least the beginning of the year, the only other fund with a substantial performance gap was the db X-trackers MSCI EAFE Hedged Equity Fund ( DBEF), which is up 8.4% year to date versus the currency-exposed iShares MSCI EAFE ETF ( EFA), which is flat this year. The gap can be attributed to both funds having 22% of their equity exposure in Japan.

There is a downside to currency-hedged ETFs. Lately, the dollar has done well, but for much of the previous decade, the dollar declined against many currencies. Just as foreign equities will again outperform domestic, so too will the pendulum swing back and foreign currencies will outperform the U.S. dollar. When that happens the foreign-equity funds that aren't hedged should outperform.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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