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WisdomTree, the New York-based ETF issuer best known for its line of earnings-weighted and dividend-weighted ETFs, announced on Monday the launch of the WisdomTree International Hedged Equity Fund (NYSEARCA:HEDJ). HEDJ is the first ETF to offer international equity exposure while neutralizing the impact of currency movements on overall returns. The fund will seek to track the performance of the WisdomTree DEFA International Hedged Equity Index, a dividend-weighted benchmark that offers exposure to Europe, Australasia, and the Far East while also neutralizing exposure to fluctuations between the value of the U.S. dollar and non-U.S. currencies reflected in the index.

Simple Concept

The rationale behind HEDJ is relatively simple: as international equities have become more accessible to U.S. investors, they have grown to represent a larger portion of most portfolios. But investors in international exchange-traded products, either knowingly or unknowingly, also take on currency risk that can have a material impact (both positive and negative) on return. This essentially means that the net return on an international ETF to a U.S.-based investors depends on both the return of the underlying holdings in the local currency (or currencies) as well as movements in exchange rates. While equity market returns are usually the primary driver, the currency impact can be material, particularly when compounded over multiple periods.

HEDJ eliminates the exposure to exchange rate movements, resulting in a fund that more closely correlates the the local country return on a basket of equities. “Traditionally when you invest in international markets you are taking on the currency exposure of those countries,” said Bruce Lavine, WisdomTree President & COO, noting that foreign currencies can both enhance returns in a weak dollar environment or erode returns when the dollar shows strength. “Now through HEDJ, investors essentially have a choice of investing in foreign equities with or without currency exposure.”

Under the Hood

In order to hedge its currency exposure, HEDJ invests in a basket of one-month forward contracts, rolling these holdings every month to provide continuous short-term exposure. As shown in the adjacent table, the fund currently has exposure to eight currencies: the euro, yen, British pound, Australian dollar, Swiss franc, Swedish krona, Singapore dollar, and Norwegian krone.

The index underlying HEDJ also maintains exposure to the Hong Kong dollar, New Zealand dollar, and Danish krone that isn’t completely hedged out, but the impact of movements in these currencies should be minimal. The Hong Kong dollar is pegged to the greenback, meaning that currency fluctuations should be minimal. New Zealand and Danish equities each account for less than 0.3% of total ETF holdings. Moreover, the Australian dollar and euro serve as decent proxies to these currencies, further minimizing the potential impact of exchange rate movements.

More to Come?

The concept behind HEDJ is a simple one, but its impact on the ETF industry could be huge. According to our ETF Screener, there are nearly 250 U.S.-listed ETF offering exposure to international equities that took in nearly $30 billion in cash through the first 11 months of 2009. International equity ETFs now have nearly $200 billion in assets, a number that will only increase as investors rethink the “home country bias” that has historically dominated the portfolio construction process.

So it’s alarming to think that the vast majority of this sum is, perhaps unknowingly, exposed to currency risk. Investors who make decisions without consideration of potential exchange rate movements may maintain a portfolio with a set of risk factors far different than imagined. It should be noted that a sizeable portion of these assets is likely hedged through other instruments (either forward contracts or “bullish dollar ETFs” like UUP), but providing both the equity exposure and the currency neutralization in one package seems like a much more efficient strategy.

ETF issuers will no doubt be keeping a close eye on HEDJ in coming months. If it proves to be popular with investors, a wave of exchange-rate neutral ETFs could hit the market in 2010.

Disclosure: No positions at time of writing.

Source: WisdomTree Launches First Currency Hedged ETF