The Currency Hedging Boom
The most dominant theme thus far in 2015 has been the global currency war, where central banks are fighting one another with new easing measures on a daily basis to debase their currencies. By my count, there have already been at least 28 easy money announcements in 2015.
The direct by-product of this race to debase has been the unprecedented boom in currency hedging. With central banks intent on crashing their currencies to lift their equity markets, U.S. investors have caught on to the game.
Out of the top 10 ETF inflows in 2015, 4 are in currency hedged ETFs (HEDJ, DBEF, DXJ, and HEFA) for a combined total of over $18 billion.
Why the stampede into hedged ETFs? Two main factors are at play.
First, you have the compelling narrative of massive QE in Japan and Europe, a crashing Yen and Euro, and the perception that there is no better way to take advantage of this than through hedged equities.
Second, performance chasing is in full effect as there have been few asset classes with better performance of late than hedged equities in Japan and Europe. Over the past five months hedged Japan (DXJ) and hedge Europe (HEDJ) are up over 32%.
A good story coupled with strong momentum is simply too much for investors to resist, especially when a crashing Euro/Yen is viewed as a “can’t lose” trade. When faced with the choice of a hedged ETF vs. a non-hedged version, the performance disparity is so glaring it is no surprise investors are overwhelmingly choosing to hedge. Since the start of 2014, the hedged Europe ETF (HEDJ) is up over 25% while a comparable unhedged version (VGK) is down 1%. Why the enormous gap? The Euro is down over 21% during that time.
Since Japan upped their QE program in 2011, the Yen has depreciated over 37% and the hedged Japan ETF (DXJ) has outperformed the unhedged version (EWJ) by 63%.
All of this hedging has been highly profitable but it will only continue to be so as long as a) the currencies continue to depreciate and b) the market continues to perceive such depreciation as bullish for equities. The danger is that few investors buying in today are likely to realize that they are predominately playing a currency debasement game in buying these hedged equities. The rolling correlation between the Yen and the Nikkei, at -.94, illustrates just how dependent Japanese equities have become on a weaker Yen.
Should there be an upward reversal in the Yen or the Euro, we would see the opposite effect and currency hedging would lower returns. The contrarian in me would say that given the massive inflows into these ETFs, perhaps we are closer to the end of the easy money debasement than investors believe. In the past year alone, we have seen assets in the hedged Europe ETF (HEDJ) increase from $1 billion to over $16 billion.
At the same time, we are seeing record net short positions held by speculators in Euro futures.
Perhaps these investors and futures traders will continue to be right and the Euro and Yen will fall from here to eternity. But on the off chance it isn’t as easy going forward, a modicum of caution may be warranted.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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