With global markets in a state of flux, currency-hedged ETFs have come into their own. This has certainly been the case with dollar-hedged ETFs, which have tended to outperform their unhedged counterparts this year.

“Investors have benefited from currency-hedged positions in Japan, Brazil and across EAFE”, says Martin Kremenstein, Head of North American ETP Management at db-X.

The reason for the outperformance has been the strength of the dollar versus other currencies. So far this year, the greenback is up against a host of other currencies.  Indeed, as of July 13, it was up 5.8% versus the euro, 1% versus Japanese yen, and 9.2% versus the Brazilian real.

These may be single-digit numbers, but in a lacklustre, low-return environment, this can be the difference between making a profit and losing money.

Underpinning dollar strength has been the search for safe havens – a theme investors have become all too familiar with. And with the eurozone mired in crisis, instability in the Middle East and slowing growth in the emerging world, when it comes to safety, few things trump the dollar.

As the world’s reserve currency, the dollar has the advantage of deep liquidity. Therefore at a time when investors are wary of buying assets they may not be able to sell quickly, the dollar has been the beneficiary of significant inflows. This has had the effect of increasing its value relative to other currencies.

It has been a similar story for pound sterling, the Canadian dollar and Australian dollar, as these, too, are broadly seen as safe-haven currencies and have thus mostly appreciated year-to-date.

Martin Kremenstein, Head of North American ETP Management at db-X, the ETP platform of Deutsche Bank, says:  “The US dollar has performed strongly against most global currencies in recent months as investors move toward safe-haven countries in light of global economic volatility.

“As we have seen with the db-X funds, investors have benefited from currency-hedged positions in Japan, Brazil and across EAFE by protecting their portfolios against the fluctuations in value of the US dollar and non-US currencies.”

With few signs of any immediate resolution to the crisis in Europe (if anything, the situation in Spain suggests the crisis is getting worse), there are many reasons to believe that safe-haven currencies – particularly the US dollar – will continue to see inflows and appreciate further.

It is important, therefore, that investors carefully consider the consequences of unhedged currency positions. For example, from the perspective of a US-based investor, part of the exposure imbedded within an unhedged international ETF is essentially a short position in the dollar relative to the currency of the country they are investing in. This may not necessarily be the investor’s intention.

Kremenstein adds:  “When a US-based investor takes a position in an international market, one must account for both the value of the underlying market and the impact of the local currency relative to the US dollar. By hedging out the currency exposure, investors can invest directly in international equity markets without worrying about the risk of currency fluctuations.

“Over the last 10 years, investors have benefited from the secular decline of the US dollar. As this decline has halted, and in most instances started to reverse itself, investors are now seeing the benefit of hedging out the currency exposure generated by their foreign equities.”

A number of ETF providers offer currency-hedged ETFs. Among the largest is Kremenstein’s Deutsche Bank, which offers a range of funds on both its US and European db-X ETF platforms. Its US, dollar-hedged ETFs include:

db-X MSCI Japan Currency-Hedged Equity Fund (DBJP)
db-X MSCI Brazil Currency-Hedged Equity Fund (DBBR)
db-X MSCI Canada Currency-Hedged Equity Fund (DBCN)
db-X MSCI EAFE Currency-Hedged Equity Fund (DBEF)
db-X MSCI Emerging Markets Currency-Hedged Equity Fund (DBEM)

These funds have been specifically designed to provide exposure to equity securities globally, while at the same time seeking to mitigate exposure to fluctuation between the value of the dollar and foreign currencies by also investing in currency forwards. As of July 13, 2012, the EAFE (DBEF), Japan (DBJP) and Brazil (DBBR) funds had all strongly outperformed their unhedged counterparts.