Why this red-hot trade could heat up once again

Currency-hedged ETFs were once the hottest trades in town. The question is whether they are set to heat up once again.

By granting investors the ability to gain exposure to foreign stocks without the currency risk that tends to be inherent in such trades, these products served as an ideal way to make popular bets that Japanese stocks will go higher while the yen will fall against the dollar (in the case of WisdomTree’s DXJ) or that European stocks will rise while the euro will fall (with the same company’s HEGJ).

These trades worked perfectly, as Japanese and euro zone stocks rose while the dollar rose against currencies around the world. As a result, DXJ and HEDJ rose 19 percent and 26 percent, respectively, in the six months up to mid-April. That represents substantial outperformance compared to currency-adjusted (that is, nonhedged) exposure to foreign stocks, as well as to the S&P 500.

In the past four weeks, however, the story has been different. The Europe hedged ETF is down nearly 5 percent, underperforming nonhedged products due to the euro’s rebound. The Japanese ETF is up just 1 percent, though it has continued to outperform nonhedged ETFs like the iShares EWJ.

The issue is that over the past month, the U.S. dollar has corrected after a long rally. That means it has recently been better to have direct exposure to foreign stocks, with the long-euro and long-yen (and thus short-dollar) positions implied by such exposure, rather than to hedge the currency side of the trade, which effectively means going long the dollar.

But if the dollar correction is over, then hedged ETFs could have their moment in the sun once again.

When it comes to selecting currency ETFs, Oppenheimer head of technical analysis Ari Wald said Tuesday that “theoretically it does make sense, because we do expect the dollar to appreciate against both the Japanese yen, and we’ll look at the European one as well, against the euro.”

And “we’re bullish on the underlying indexes. So I do expect these ETFs to do well,” Wald said.

However, currency trader Boris Schlossberg of BK Asset Management said that it’s exceedingly difficult to nail such multifaceted trades.

“I think when you’re making a trade on European equities or other currency positions, you should just take the currency risk,” Schlossberg said Tuesday. “It’s very, very difficult to figure out where the currency is going to head. So you want to be buying the asset for its own intrinsic value and kind of let the currency fluctuations take care of themselves. I generally don’t think it’s a great idea.”

However, if the dollar does indeed start to tick higher against the euro and the yen, investors who buy the DXJ or HEDJ instead of a nonhedged ETF could begin to reap handsome rewards once again–so long as European and Japanese stocks continue to cooperate.

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