ETF Trends For 2016: Part 1, Currency-Hedged Products

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Includes: AGG, BITE, DB, DBEF, DXJ, EWJ, HEDJ, VGK, VOO, VTI, WETF, XT
by: SA Editor Carolyn Pairitz Morris

Summary

In this first piece of the article series, we are going to cover currency-hedged products, while parts 2 and 3 will be on robo investors and expense ratios respectively.

Investor interest in specialized tools to conquer the market is growing.

There are over 50 ETFs with a mandate to not only invest in equities from a region, but also neutralize exposure to fluctuations between that region’s currency and another.

2015: A Quick Look Back

Constant talk of interest rate hikes, the China market correction in August and the start of 'chip' credit cards in the U.S. - these are the things I believe will stand out in my mind if asked 10 years from now what happened in the world of finance in 2015. However, for Exchange Traded Funds (ETFs) 2015 was all about the continuing growth of Smart Beta strategies, the potential for Non-Transparent Exchange Traded Mutual Funds and new niche funds (like the iShares Exponential Technologies ETF (NYSEARCA:XT) or the Restaurant ETF (NASDAQ:BITE)).

According to ETF.com:

As of Dec. 3, 2015, 270 ETFs had launched on U.S. exchanges. That is far beyond the roughly 200 funds that rolled out in 2014, and sets 2015 up to be a record-breaking year. You have to go back nearly a decade to find a year that achieved a similar number of launches.

As shown by the above image from the ICI 2015 Investment Company Fact Book, ETFs continue to grow in assets under management (AUM) and the number of fund offerings for investors. However, ETFs have yet to overtake mutual funds. But at current growth rates, ETFs will see parity soon enough.

According to an article from Camilla de Villiers of Thomson Reuters:

ETF assets today are expanding by 24% per annum - triple the rate of traditional mutual funds. Notwithstanding their popularity, ETFs have fallen well short of displacing the $16 trillion mutual fund industry. But over the long term, on current rates of growth, mutual funds and ETFs will reach parity at $50 trillion each by 2030.

Earlier this year, Schwab commissioned an online study to gauge U.S. investor interest in ETFs (pdf download linked here). The full report is a great read and full of useful data, but one key point especially stood out. As ETF interest continues to grow, we also see that the most avid users are the tech savvy first adaptors, millennials.

As of publication, we can see (using ETF.com's Fund Flows tool) investors in 2015 were not just interested in plain vanilla market cap-weighted funds, but their interest in specialized tools to conquer the market has continued to grow. However, old standbys like the Vanguard S&P 500 ETF (NYSEARCA:VOO), the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) and the Vanguard Total Stock Market (NYSEARCA:VTI) do continue to see investor appreciation.

But the continuing impressive growth of ETF assets is to some extent old news in the investing world. What we'd like to focus on in the rest of this brief report are 3 key industry trends and their implications for the continued success of ETFs in the future. In this first part, we are going to cover currency-hedged products, while parts 2 and 3 will be on robo investors and expense ratios respectively.

Currency-Hedged Products & Iterations On A Theme

WisdomTree (NASDAQ:WETF) launched its first currency-hedged fund in 2006, the Japan Hedged Equity Fund (NYSEARCA:DXJ), and it took three-and-a-half years for them to launch a second, the Europe Hedged Equity Fund (NYSEARCA:HEDJ). Clearly the idea didn't catch fire right away, but it is growing rapidly now. There are now over 50 ETFs with a mandate to not only invest in equities from a region, but also neutralize exposure to fluctuations between that region's currency and another (often the U.S. dollar). HEDJ and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA:DBEF) even led fund creations for 2015, with $15.77 and $12.67 billion respectively, as concerns around a weakening euro hit investors.

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This slight change in mandate from your average international-focused index fund can have a dramatic effect on returns. For example, see DXJ and HEDJ's 5-year returns against two popular non-hedged funds tracking Japan and Europe as well, the iShares MSCI Japan ETF (NYSEARCA:EWJ) and the Vanguard FTSE Europe ETF (NYSEARCA:VGK).

To be fair, a currency hedge can be a negative thing for investors as well. When the dollar starts to fall against a foreign currency, currency-hedged investors lose out on the gain from this relationship. As stated by Chris Dieterich of Barron's:

For now, WisdomTree's stock looks likely to behave as a leveraged play on the dollar. The higher the greenback goes, the more traders will clamor for currency-hedged ETFs.

When wondering where the push for these funds came from finally and where they will go from here, we turn to a quote from Greg McFarlane of Investopedia:

The upsurge in currency-hedged ETFs is a recent phenomenon spurred by an unmistakable cause - national banking authorities obsessed with inexpensive money. Players are entering the market at an alarming rate. With more such ETFs available to the individual investor, and firms thus forced to compete on price (which is to say, expense ratios), there's never been a better time to not only expose yourself to international markets, but reduce price movement risks while doing so.

Deutsche Bank (NYSE:DB), iShares and WisdomTree lead the fund creation march now, but IndexIQ is the first to look outside the standard currency-hedged product box in the quest for differentiation and further investor assets. Its recently launched lineup of 50% currency-hedged ETFs each hedge approximately 50% of its foreign currency exposure to mitigate the effect of currency fluctuation on USD index returns rather than the traditional 100% hedge. These kinds of iterations on a theme will only offer investors further options when considering a currency-hedged strategy.

Stay tuned for part 2 next week, which will focus on the rise of robo investors and how this industry will affect ETF investors and continue to grow in 2016.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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