A strengthening dollar is driving a shift toward investment products that are currency-hedged, Mohit Bajaj, director, ETF and portfolio trading services at WallachBeth Capital, a provider of institutional execution services, told Markets Media.

“What we have seen in the dollar has been strengthening compared to competitors.” Bajaj said. “That’s why you keep seeing underperformance in a lot of the European ETFs that are not hedged, such as VGK [Vanguard FTSE Europe ETF]. What happens is people start investing more in hedged European products because they want the great performance of Europe, but they don’t like underperformance of the Euro.”

Bajaj will speak on an ETF panel at Markets Media’s Canadian Trading & Investing Summit, which will be held April 1 in Toronto. The panel will cover the growth of the Canadian ETF industry, the current landscape, and the challenges and opportunities ahead.

An example of a currency-hedged European ETF is the WisdomTree Europe Hedged Equity Fund, which implements a currency hedging strategy by entering into one-month forward contracts each month and rebalancing at month-end.

Based on a comparison of indexes that are exposed to the performance of the euro versus the U.S. dollar against those that solely generate exposure to the performance of the locally denominated equities, the beta of European equities in U.S. dollars has been approximately 36% higher than that of European equities in local currency, according to a WisdomTree fact sheet.

As for Canadian ETFs, Bajaj said that they are tilted toward commodities and financial services, the country’s largest industries by far. “EWC [iShares MSCI Canada ETF] is very highly levered to energy and financials,” he said. “EWC is basically 20 percent energy, about 10 percent materials and the rest is mostly financial.”

Institutional investors are increasingly using ETFs, according to Bajaj. “We have seen a lot of institutional investors in ETFs over the past five years now,” he said. “It’s becoming a much bigger piece of their portfolio allocations. Let’s say you have a portfolio that has a lot of financial stocks. It’s much easier for the portfolio manager to manage the single ETF rather than 20, 30, 40 different stocks that are very highly correlated to each other.”

Utility and fixed income ETFs could take a hit once expected rate hikes by the Federal Reserve are announced.

“There’s chatter on interest-rate hikes,” Bajaj said. “What we’ve seen recently is outflows of XLU, which is a utilities ETF, because rising interest rates are adversely affecting the utility companies. When rates rise, they are very highly levered to debt financing. So, if their costs were to increase, then you’ll see underperformance in utility names.”

As for fixed income, “we’ve seen a lot of outflows because, when rates go up, prices go down,” said Bajaj. “Especially the ones that are longer dated with higher duration, like the 30 year bonds, are more susceptible to underperformance when there is a rate hike. What’s going to happen is that the yield curve will slowly start to flatten. When that happens, it’s going to cause bonds to become cheaper. “

Feature image by Vladi Mir/Dollar Photo Club