What has been one of the most important drivers of the negative total return within emerging market (EM) investment strategies in 2015? The answer: currency. For the first three quarters of 2015, emerging market currencies have depreciated compared to the U.S. dollar—some much more significantly than others. At the worst end of the spectrum, the Brazilian real lost approximately one-third of its value measured against the U.S. dollar, and on the other end of the spectrum, the Chinese yuan—a currency often remarked upon for the lack of a market-determined exchange rate—even lost a few percentage points of its value against the dollar.1
Why Not Currency Hedge?
The answer is simple: Because it’s expensive. The cost to hedge emerging market currencies is quite high because these economies have much higher short-term interst rates
than the U.S., with the Federal Funds Rate
still targeting a range of 0% to 0.25%.2
Taking the Brazil example: Using one-month forward contracts
to initiate a hedge of the Brazilian real versus the U.S. dollar, there is a 13% difference in short-term interest rates between Brazil and the United States, and that is the cost to hedge the real versus the U.S. dollar.3
Being Contrarian while Managing the Currency Risk: Emerging Market Corporate Bonds Issued in U.S. Dollars
One of the notable contrarian investments today would be emerging markets, as performance has been challenged. But there is good news: Not all EM investments have as much currency risk.
While the emerging market sovereign
bond market is moving more and more toward debt issued in local currency, thereby better matching government revenues
with government liabilities
, the large majority of emerging market corporates issue debt denominated in U.S. dollars. This means that an investor can gain exposure to emerging market corporate credit
without needing to have exposure to the performance of emerging market currencies against the U.S. dollar.
Note, unlike many of the sovereign countries that issue their debt in U.S. dollars and earn revenue solely in their local currencies– leading to a different and often hidden currency risk due to the debt being owed to lenders in U.S. dollars—many emerging market corporations, especially commodity-centric ones, also earn their revenue in U.S. dollars. These emerging market corporations therefore have a better asset and liability matching than the countries issuing debt in U.S. dollars.
WisdomTree has partnered with Western Asset Management Company in just such a strategy—the WisdomTree Emerging Markets Corporate Bond Fund (EMCB)
—since March 2012. Given that currency has been a major headwind in emerging markets during the first three quarters of 2015, we show how EMCB performed compared to other emerging market assets, knowing that it avoided the currency impact. We also looked at the third quarter of 2015 performance, as this quarter was marked by significant volatility
Average Annual Returns as of September 30, 2015
EMCB Outperformers over Year-to-Date & the Third Quarter of 2015
• EMCB as Least Negative:
While neutralizing the currency headwind to returns did improve the picture, it was still not quite enough for a positive return. However, this shows just how important it is to think carefully about different emerging market options. We think that pairing an investment vehicle like EMCB with other emerging market investments that may have currency exposure could offer an interesting strategy.
• CEW Provides a Diversified Metric for Emerging Market Currency Performance:
CEW represents a basket of 15 emerging market currencies, all rebalanced back to an equally weighted 6.67% each quarter. Its performance, at least in part, provides an interesting window into how emerging market currencies, broadly, are faring against the U.S. dollar. The one caveat to this is that, as of September 30, 2015, embedded income yield
of these positions was in the neighborhood of 5.5%, and this would provide a cushion to any decline in the spot prices of the represented currencies against the U.S. dollar. (See current standardized yield information for CEW). XSOE
—exchange-traded funds designed to track the performance of equity indexes4
—do not have exposure to this cushion. It’s also worth noting that it is precisely this cushion that makes hedging these currencies with forward contracts more expensive.
Implementing an Emerging Market Strategy in the Fourth Quarter of 2015
While we believe that emerging market asset classes may be getting to a point where the negative performance and present valuations
may appropriately reflect the inherent risks, it still does not make allocating there easy—especially with things like the U.S. Federal Reserve
interest rate decision, China’s economic growth picture and a commodity price recovery all being open questions. Investors often use bonds in the U.S. to mitigate the volatility of equities. This strategy could work very well for those who want to increase their exposure to the emerging market asset class.
Source: Bloomberg, for period 12/31/14–9/30/15.
Source: Bloomberg, as of 9/30/15.
Source: Bloomberg, as of 9/30/15.
Specifically, XSOE tracks the WisdomTree Emerging Markets ex-State-Owned Enterprises Index
; DGS tracks the WisdomTree Emerging Markets SmallCap Dividend Index
; DGRE tracks the WisdomTree Emerging Markets Quality Dividend Growth Index
; DEM tracks the WisdomTree Emerging Markets High Dividend Index
; and EMCG tracks the WisdomTree Emerging Markets Consumer Growth Index