WisdomTree AND CURRENCY HEDGING
WHAT IS CURRENCY HEDGING?
International investing provides many exciting opportunities to investors. But these opportunities come with additional risks—one of which is currency fluctuations. While currency can sometimes push equity returns higher, it can often pull returns down—and these fluctuations are typically a source of uncertainty.
Currency hedging is a strategy designed to mitigate the impact of currency or foreign exchange (FX) risk on international investments returns. Popular methods for hedging currency are forward contracts, spot contracts, and foreign currency options.
At WisdomTree, we have been implementing currency-hedging strategies for the last five years—in a way that is likely simpler and more cost-effective1 than many investors expect. The bottom line is that currency hedging allows investors to participate more fully in the local equity returns of international markets.
MECHANICS OF THE CURRENCY HEDGE
Here is how currency hedging typically works at WisdomTree:
1 Ordinary brokerage commissions apply.
WHY HEDGE FOREIGN CURRENCIES?
Investors allocating to foreign stocks typically assume a secondary risk exposure from currency. This risk is due to the difference between what the foreign currency is worth and what the dollar is worth. This “currency bet,” as some might call it, can help increase total returns during periods when the euro, yen and other foreign currencies are rising versus the dollar.
But it can also help reduce returns when those foreign currencies are falling in value. We believe that investors who do not have strong opinions on the potential direction of a currency should hedge at least a portion of their exposure in that currency.
Typically, it is only expensive to hedge foreign currencies that have much higher short-term interest rates than the United States, as is the case in Brazil, for example. However, the euro, yen and British pound—which combine to represent almost three-quarters of the weight of the MSCI EAFE Index (a widely followed benchmark composed of companies representative of the developed market structure of 21 developed countries in Europe, Australasia and Japan) —each has a very low cost to hedge, as figure 1 shows. In addition, as U.S. rates rise relative to rates in Europe and Japan, dollar-based investors could be paid to hedge euro and yen exposure. Put another way, it could become “expensive” for investors not to hedge their euro and yen exposure.
Source: WisdomTree, Bloomberg, with data as of 9/30/2016. Past performance is not indicative of future results.
The values of the euro and yen, in essence, do not make good hedges against U.S. inflation rates or declining U.S. dollar purchasing power. What does make a potentially good hedge against inflation? We believe that stocks representing claims on real assets and/or those that have historically seen their dividends grow with inflation over time make better hedges against inflation. As figure 2 shows, dividend growth on the S&P 500 Index and MSCI EAFE Index kept better pace with—and often outpaced—CPI in periods of high inflation, while currency returns did not.
One of the arguments we hear often is that, due to a concept called purchasing power parity (PPP), currencies offer no expected return in the long run and are therefore a wash. Yet currencies tend to move in very long secular trends. Interestingly, international equities actually saw their strongest returns during down currency trends (as shown in figures 3A and 3B). And when the currency is down, that can detract from the returns unless investors hedge their currency exposure.
Source: MSCI, with data as of 9/30/2016. Past performance is not indicative of future results. You cannot invest directly in an index.
Source: MSCI, with data as of 9/30/2016. Past performance is not indicative of future results. You cannot invest directly in an index.
STRATEGIC & TACTICAL HEDGING
The strength of the U.S. dollar relative to currencies like the euro or the yen can erode international returns if left unhedged. And some countries are pursuing monetary policies that may weaken the value of their currency.
Additionally, currency exposure can offer an added risk with little (or no) positive expected returns—something we’d call a source of “uncompensated risk.” Although this risk has long been seen as a “necessary evil” of international equity investing, it doesn’t have to be.
For investors with a negative outlook on a particular currency or more generally, those who believe that the dollar is going to strengthen, currency hedging is an important option, as it can enable them to pursue the international equity market returns without a drag from foreign currency weakness.
Currency can make a big difference—even in the short term. In the Abenomics period starting November 30, 2012 and ending September 30, 2016, the MSCI Japan Index returned 44.4%—a decent return until it is compared to the WisdomTree Japan Hedged Equity Index, which achieved a 61.7% return over the same timeframe! The difference? The WisdomTree Index hedges the yen, which lost 18.6% over the same period, while the MSCI index does not.
And there were similar results throughout Europe, where the WisdomTree Europe Hedged Equity Index returned 16.1%, while the MSCI EMU Index lost 9.7% and the euro lost 18.2%.
WHY HEDGE DYNAMICALLY?
Historical data confirms that currency volatility can impact international investments over short- and long-term holding periods. While currency hedging has obvious advantages, some investors may not want the challenge of timing U.S. dollar strength or weakness. Building on our expertise in currency hedging, WisdomTree pioneered dynamic currency hedging, an adaptive strategy suited for long-term investors concerned about the impact of currency fluctuations on international equity holdings.
- Many leave it to their active manager to make the hedge/no hedge decision, but most of these managers typically specialize in stock selection, not currencies
- Dynamic hedging can solve the challenge of trying to "time" when a currency hedge should be in place and thus could serve as a core, long-run allocation
- Dynamic hedging may lower trading costs and increase tax efficiency when compared to a strategy that rotates between hedged and unhedged solutions
How Is It Achieved?
- WisdomTree partnered with Record Currency Management, a currency manager with over 30 years of experience, to determine hedging signals for the new Index family1
- Targeting Profitable Hedges: The strategy targets mid to long-term excess returns by seeking greater exposure to hedges with expected profitability versus hedges that are expected to generate losses
- Diversification by Signal Time Horizon: Signals used to determine hedges (interest rates , value, momentum) have diversification in time horizon efficacy
1No WisdomTree Fund is sponsored, endorsed, sold or promoted by Record Currency Management (“Record”). Record has licensed certain rights to WisdomTree Investments, Inc., as the Index provider to the applicable WisdomTree Funds, and Record is providing no investment advice to any WisdomTree Fund or its advisers. Record makes no representation or warranty, expressed or implied, to the owners of any WisdomTree Fund regarding any associated risks or the advisability of investing in any WisdomTree Fund. Past performance is not indicative of future results. You cannot invest directly in an index.
EUROPE & INTERNATIONAL CURRENCY-HEDGED FUNDS
International investments should have a place in every portfolio, and now may be an opportune time to add them.
Of course, we believe that international equities tend to perform better when the U.S. dollar is strengthening—and if history repeats, we may be on the cusp of a prolonged period with a rising dollar. And if the dollar is rising, other currencies are often weakening. Hedging them can help to reduce volatility.
EUROPE HEDGED EQUITY FAMILY
The European Central Bank’s recent monetary easing policies have helped our Europe Hedged Equity family perform well. Not only are many of the world's leading companies—and familiar brands—headquartered in Europe, but these are truly global companies that generate the bulk of their revenue from exporting to countries outside Europe. Our family of European Hedged Equity Funds offers investors a way to more fully access the return potential of European equities while hedging the effects of the currencies.
EUROPE HEDGED EQUITY FUND
WisdomTree Europe Hedged Equity Fund (HEDJ) offers a way to access the growth potential of leading global companies while hedging exposure to the euro.
DYNAMIC CURRENCY HEDGED EUROPE EQUITY FUND
The WisdomTree Dynamic Currency Hedged Europe Equity Fund provides dividend-weighted access to eurozone dividend payers with a proprietary, dynamic currency hedge seeking to take the question of whether to hedge or not to hedge the euro off the table.
EUROPE HEDGED SMALLCAP EQUITY FUND
Small companies are typically more sensitive to local demand, and if Europe is able to stem the tide of deflationary risk, these companies may have significant potential. WisdomTree Europe Hedged SmallCap Equity Fund (EUSC) enables investors to fully capture the potential of small European companies without being sensitive to the risk of the euro.
GERMANY HEDGED EQUITY FUND
Germany is one of the engines of European growth. It has been a resilient force throughout the debt crisis and should benefit if a broader European recovery can take hold. Even so, we think some of the best times to own German stocks have been when Germany’s currency has been declining. WisdomTree Germany Hedged Equity Fund (DXGE) offers investors a way to capitalize on the growth potential of the tremendous German exporters while hedging out the effects of the euro, helping reduce volatility and capturing the performance of these stocks as their revenues potentially increase in a depreciating euro environment.
UNITED KINGDOM HEDGED EQUITY FUND
London is a major financial center in Europe so, understandably, many of the world’s leading companies list their stocks there—even if they are physically headquartered elsewhere. The WisdomTree United Kingdom Hedged Equity Fund (DXPS) provides the ability to capitalize on the growth potential of leading global companies while hedging exposure to the British pound.
INTERNATIONAL HEDGED QUALITY DIVIDEND GROWTH FUND
The WisdomTree International Hedged Quality Dividend Growth Fund (IHDG), which covers the same 21 markets as the MSCI EAFE Index, uses WisdomTree’s proprietary growth and quality methodology to identify companies with better chances of future dividend growth. In essence, the approach focuses on the potential dividend growers of tomorrow without the currency risk associated with international markets.
DYNAMIC CURRENCY HEDGED INTERNATIONAL QUALITY DIVIDEND GROWTH FUND
WisdomTree Dynamic Currency Hedged International Quality Dividend Growth Fund emphasizes growth and quality traits of selected companies in the developed world ex-U.S. and Canada while dynamically hedging exposure of foreign currencies against the U.S. dollar, seeking to eliminate the need for investors to think about timing currency movements.
GLOBAL HEDGED SMALLCAP DIVIDEND FUND
Global small-caps can offer big dividends that make them highly desirable for those seeking income and higher return potential. But some may also layer currency risk on top of equity risk. The WisdomTree Global Hedged SmallCap Dividend Fund (HGSD) enables investors to capitalize on the big potential of small companies all over the world, while hedging the exposure to the currencies.
DYNAMIC CURRENCY HEDGED INTERNATIONAL SMALLCAP EQUITY FUND
The WisdomTree Dynamic Currency Hedged International SmallCap Equity Fund combines income potential via developed world ex-U.S. and Canada small-cap dividend payers with a proprietary, rules-based dynamic currency hedge seeking to eliminate the need to time currency fluctuations.
DYNAMIC CURRENCY HEDGED INTERNATIONAL EQUITY FUND
The WisdomTree Dynamic Currency Hedged International Equity Fund provides access to a broad lineup of developed world ex-U.S. and Canada dividend payers while seeking to eliminate the need for investors to think about when to hedge and when not to hedge currency exposure.
GLOBAL EX-U.S. HEDGED EQUITY
GLOBAL EX-U.S. HEDGED DIVIDEND FUND
International companies offer many of the products and services you know and trust. Far from being foreign, international companies play a part in our lives every day. They often represent the technologies we use, the cars we drive, the clothes we wear, the coffee we drink. And these dividend paying equities offer many advantages to investors. The WisdomTree Global ex-U.S. Hedged Dividend Fund (DXUS) can help investors capitalize on the benefits of these international equities and mitigate the currency risk.
GLOBAL EX-U.S. HEDGED REAL ESTATE FUND
Investors all over the world seek income. And global real estate investments provide the potential for income that can grow with inflation and provide many other advantages too. The WisdomTree Global ex-U.S. Hedged Real Estate Fund (HDRW) provides investors with a way to capitalize on benefits of global real estate, while hedging the effects of the currencies.
The EUSC, HDLS, DXUS and HDRW Funds are new and have limited operating history.
Visit our blog to learn more about currency-hedged ETFs.
1 Based on the MSCI ACWI Index. a broadly recognized global benchmark, universe, as of 3/31/15; Source: Bloomberg.