ETFs have grown in popularity over the past couple of decades. They started out as plain-vanilla products but have expanded their sophistication over the years. Not only are there funds tracking broad market indexes, but more and more are employing complex strategies such as factor-based, hedging, long/short, leveraged, floating rate, inverse, and smart beta. ETFs utilizing hedging strategies have targeted currency and interest rate risks. These funds have piqued the interest of investors as they have specifically identified the type of risk they are providing protection against and have proven successful at mitigating those risks as they materialized.
Typically, when a U.S.-based investor buys an international stock fund, they get exposure to both that country’s stocks and its currency. For example, if Japanese stocks rise 2% and the yen increases 1% against the dollar, then a typical Japan ETF would return 3%. With the converse, if stocks climbed 2% but the yen fell 1%, then the fund would only return 1%. In a fund that is hedged to avoid the currency impact, investors would have earned only the stock return of 2%.
Currency fluctuations can also have a dramatic effect on large multinational corporations. As the dollar increases in value, the profits generated overseas are reduced when converted back to dollars. If the U.S. currency climbs by 10%, the foreign profits realized by a U.S. global corporation would be worth 10% less when viewed in dollar terms. Global companies are just as sophisticated, if not more so, than an ETF and can successfully hedge against currency fluctuations if they so choose. Earnings season begins in a few weeks, and results will reveal which firms are hedging and which ones aren’t.
There are ETFs in the bond realm that hedge against rising interest rates. As rates rise, newly issued bonds become more attractive than existing ones because the older issues have lower interest rates. This results in a loss of value for funds holding the older bonds. To offset the decline, interest-rate-hedged funds short Treasury futures, a bet that pays off when interest rates rise.
This theory is even more interesting after the conclusion of the Fed’s FOMC meeting today. The Federal Reserve dropped its stance to be “patient” in raising interest rates and opened the door to an increase in June. The FOMC said tightening could commence “when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” This comes on the heels of the February employment reports indicating the economy has seen twelve months in a row of payrolls growing by 200,000 or more. Although interest-rate-hedged ETFs may sound promising as it looks more likely the Fed will begin raising rates sooner rather than later, please be aware most of these funds are relatively new and have not yet been fully tested by the market.
Health Care has been on a market-beating trend for most of the past ten months. It had some minor setbacks in December and early February but is now back on track. Health Care climbed a notch to secure the top sector ranking this week, a position it last held fourteen weeks ago. Consumer Discretionary added to its momentum, but the strength in Health Care pushed it down a rung and out of the first place position it held the past five weeks. Financials jumped three places higher to third as successful stress test results provided an upside catalyst. Technology and Industrials both slipped one spot lower due to the rise of Financials. Real Estate rebounded strongly, climbed three places higher, and moved from the red back into a slightly positive trend. Telecom and Consumer Staples swapped places and are both still hovering around the zero line. Materials dropped four places in the rankings and gave up its last little bit of positive momentum. The Utilities sector was in the basement the past four weeks, but it improved that standing today. We would like to say it “climbed” higher, but it was actually the plunge of Energy that was responsible for the change. Crude oil prices dropped to a new six-year low, which dragged the entire Energy sector lower.
Growth has been the controlling criteria in the style rankings the past few months, as Growth versus Value characteristics trumped company size. Just two weeks ago, the style categories were neatly organized with Growth at the top, Blend in the middle, and Value at the bottom. Today, the lineup appears much more jumbled, although closer inspection reveals that smaller capitalization stocks are gaining relative strength. Small Cap Growth embodies both the previous and current trends, allowing it to remain on top for an eighth week. Micro Cap climbed another rung and now occupies second place, pushing Mid Cap Growth down a spot in the process. Small Cap Blend and Large Cap Growth swapped places with Small Cap Blend gaining the edge. Small Cap Value jumped three places to seventh as another example of strength shifting to smaller companies. There are no longer any Small Cap categories in the bottom four, as Large Cap Blend, Mid Cap Value, Mega Cap, and Large Cap Value now hold these positions. Although it remains in last place, Large Cap Value did manage to move slightly into the green this week.
Japan increased its upside momentum and put more distance between itself and the other global categories. The global rankings are easily the most divergent at this time with 92 points separating the top from the bottom. For comparison, just 61 points define the range of the sector categories, and the style category extremes span just a 28-point differential. The U.S. managed to hold on to its second place ranking while China jumped four places to grab third. The rebound in Chinese shares was enough to put the country back in a positive trend. The strength in China pushed EAFE, Europe, and World Equity all a notch lower. The bottom five categories are in the red. Pacific ex-Japan currently leads this rag-tag bunch as the U.K. took a tumble. Emerging Markets, Canada, and Latin America have been the lagging trio for eight consecutive weeks. While Japan has a large margin over the U.S. at the top of the rankings, Latin America has a large inverse margin to Canada above it.
“An increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting.”
From the Federal Open Market Committee statement released 3/18/15
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