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If you were to ask most individual investors or financial advisors their take on the outlook for the Indian rupee or Swedish krona, most would probably respond with a blank stare. But most of those same investors probably maintain some degree of currency exposure in their portfolios, especially if any of the $190 billion in international equity ETFs belongs to them.

Returns on the vast majority of international equity ETFs depend not only on the performance of the securities in their local market, but on the changes in the value of the local currency relative to an investor’s home currency. The currency component of total returns is generally relatively minor compared to the equity component, but can certainly have a material impact on a security’s bottom line return.

The scenario that has played out in Europe in the first half of 2010 serves as an excellent example. U.S. investors have watched their euro-denominated investments take a beating from multiple sides; dismal economic conditions have hammered the value of stocks on local markets, and a plunging euro has further diminished the U.S. dollar value of these securities. It’s no coincidence that the best-performing ETFs in the Europe Equities ETFdb Category offer exposure to markets that haven’t adopted the euro, including Sweden, Norway, and Switzerland.

Yen Dilemma

The issues surrounding Japanese equities and the yen are perhaps even more complex. Despite a languishing economy, Japan’s currency has shown impressive strength against the U.S. dollar recently, a phenomenon many attribute to an unwinding of the “carry trade” in which investors borrow money at low interest rates in one currency and invest at a higher interest rate in another currency. For years, the yen was the borrowing currency of choice. But now large institutional investors have begun exiting that trade by buying yen, sending the currency’s value higher.

Foreign currency strength is usually a benefit to U.S. investors in international equities, but that rule hasn’t held in Japan in recent years. A stronger yen battered Japan’s massive export industry, making the country’s goods more expensive to overseas consumers. Toyota estimated that every one point move in the yen against the dollar cost the company 30 billion yen. In 2006, it took about 115 yen to purchase one dollar; today it takes less than 90. In the U.S. a strong dollar is often cheered, as it makes European vacations or imported TVs more affordable. But a strong yen has been a thorn in the side of the Japanese economy in recent years, stunting growth in the all-important export sector.

The country’s new prime minister clearly favors a weaker yen, and has made a decline in the value of the currency a primary goal of his administration. So on one hand, investors in Japanese equities are cheering for a weaker yen, a development that would make the country’s massive export market more competitive and perhaps kickstart an economy that has been stalled for the better part of two decades. But on the other hand for U.S. investors, a weaker yen comes with a not-so-immaterial down side, as it erodes the dollar value of investments in Japanese equities.

Hedged Equity ETFs

For investors who would rather avoid the issues surrounding currency exposure, there are a couple of interesting ETF options. WisdomTree, the New York-based firm best known for its fundamentals-weighted ETFs, has pioneered the hedged equity ETF space, rolling out two funds that seek to strip out the currency component from international equity exposure:

Japan Hedged Equity Fund (NYSEARCA:DXJ)

This ETF from the Japan Equities ETFdb Category provides exposure to equity securities in Japan while at the same time hedging exposure to fluctuations between the value of the U.S. dollar and and the Japanese yen through the use of currency forward contracts. DXJ maintains near perfect correlation with other Japan ETFs, but solves the “yen dilemma” many U.S. investors face when considering Japan. If Japanese markets get a boost from a weakening yen, investors won’t experience the “currency drag” that will likely sting many other Japan ETFs.

International Hedged Equity Fund (NYSEARCA:HEDJ)

WisdomTree also offers a hedged equity alternative to EFA, the popular EAFE ETF. HEDJ tracks the performance of the DEFA International Hedged Equity Index, a dividend-weighted benchmark that offers exposure to non-U.S. developed markets while neutralizing exposure to exchange rates between the dollar and non-U.S. currencies. Much like the ultra-popular EFA (which has about $33 billion in assets), HEDJ includes exposure to Western Europe, Japan, Australia, and a handful of other advanced economies.

To Hedge Or Not To Hedge?

Currency hedging may not be for everyone. Fluctuations in exchange rates are ultimately a zero sum game that sometimes works in favor of investors and other times works against them. In many instances, investors are happy to maintain exposure to other interest rates. While it won’t make sense for every investor to replace EWJ with DXJ and EFA with HEDJ, these hedged equity funds offer investors an interesting option, and add another tool to the portfolio toolkit. If you’d prefer to minimize your currency exposure, these ETFs might be worth a closer look.

Disclosure: No positions at time of writing.

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Source: Two Hedged Equity ETFs for Your Portfolio