Hedged ETFs: Set It and Forget It? Forget It

Simpler is often better for individual investors, so the new and fast-growing hedged exchange-traded fund raises a question: Is packaging institutional-style trades into ETFs and offering them at low cost to the masses democratic or dangerous?

These products let investors bet on an asset -- Japanese stocks, for example -- while getting rid of a risk in the trade that they don't want, like exposure to the yen. After starting in equities, hedged ETFs have infiltrated every asset class and grown 1,000 percent to $15 billion since the start of 2013. And to answer the question, making these trades available to retail investors is democratic. And dangerous.

On the equity side, the best known and largest of the hedged products is the $12 billion WisdomTree Japan Hedged Equity ETF (DXJ ). It packages the trade just mentioned -- going long, or betting on a rise, in Japanese stocks and shorting, or betting against, a rise in the yen. It was 2013’s blockbuster, the ETF equivalent of a James Cameron movie, gaining 41 percent for the year and attracting over $9 billion in assets. That $9 billion was the second-biggest haul for the year for an ETF, behind the SPDR S&P 500 Trust (SPY ).

Since DXJ's success, the number of currency hedged ETFs has tripled. There are now 24 of them, covering Germany, Mexico and South Korea, to name a few. Here's a sampling of two other asset classes where hedged ETFs are popping up, along with the risks they're designed to avoid -- and the risks they bring.

Hedging Rate Risk

In the fixed-income world, there's been a flurry of interest in bond ETFs that attempt to cancel out interest-rate risk. It's a timely product as the Fed tapers its monthly bond buying. The largest of these is the ProShares High Yield-Interest Rate Hedged ETF (HYHG ). Rising interest rates would send high-yield bond prices down. To mitigate that risk to its portfolio, the ETF goes long high-yield bonds while shorting Treasuries. If it sounds complex, that's because it is, and that’s why trades like these have largely been left to institutional investors. HYHG has been steadily growing in assets since its inception in May and is nearing the $100 million mark. It's gained 4 percent since inception and yields about 3 percent.

In commodities, a new raft of hedged gold ETFs was launched in mid-February. The AdvisorShares Gartman Gold/Yen ETF (GYEN ) invests in gold futures, betting that gold's price will rise, while shorting currency futures (in this case, the yen). GYEN borrows yen, converts the yen into U.S. dollars at the foreign exchange rate and then uses the U.S. dollar proceeds to buy gold. The case for doing this: Sometimes other currencies depreciate more than the dollar, so you can get more out of your gold investment if it's denominated in another currency. Last year, gold in dollars was down 29 percent but gold in yen was down only 6 percent because the yen lost so much value -- it fell 21 percent. AdvisorShares also rolled out a gold/British pound and gold/euro ETF.

Buyer Beware

When the trade goes the wrong way, it can be a double whammy. DXJ's a good example. In 2013, it returned 41 percent compared to the 26 percent gain for the non-hedged iShares MSCI Japan ETF (EWJ ). What happens when Japanese stocks decline and the yen rises for an extended period? DXJ will inevitably go down more than EWJ. So you get double the fun on the way up and twice the angst on the way down. The trade isn't working so well in 2014 for DXJ, and it's down 6.7 percent so far, compared to the non-hedged EWJ’s decline of 4.8 percent.

Shorting currency hasn't been working with hedged ETFs focused on Germany, either. The unhedged iShares MSCI Germany ETF (EWG ) is up 27 percent, while the db X-trackers MSCI Germany Hedged Equity Fund (DBGR ) is up 15 percent. That's one reason DBGR has attracted only $41 million since inception.

How should retail investors think about these products? Brandon Conway of Barron’s wrote recently that "the rise of ETFs that add yen, euro, or peso nuance to stocks is really about short-term investing. History shows that those [investors] with a long horizon and broad diversification usually can wait out currency fluctuations.”

For the average investor, this is all brand new. While innovation is often a good thing, the explosion of new products can outpace our financial education. So when investors consider an ETF that says it is “hedged” or “zero duration” or “gold/yen,” they need to remember they're making two bets at once, and that those bets need to be monitored.

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