Three Approaches to International Small Caps: A 10 Year Retrospective

Executive Vice President, Global Head of Research

Earlier this year, we celebrated the 10-year anniversary of the launch of the first small-cap international exchange-traded fund (ETF) in the United States, the WisdomTree International SmallCap Dividend ETF (DLS). We saw the value in small-cap investing and the diversification it can add to portfolios. We asked, if investors have benefited from small-cap investing in their allocations to the United States, and particularly small-cap investing with a value-based orientation like the one our dividend-weighted Indexes incorporate, why should they not have that same opportunity for international allocations? Our investors agreed. DLS resonated from its launch on day one, and it became our biggest ETF less than one year after its launch, based on its assets under management. DLS remains one of WisdomTree’s largest ETFs, with more than $1 billion in assets 10 years later. Questioning the Role of Currency Risk A few years after we launched, around 2008, the U.S. dollar was in the midst of a seven- to eight-year decline, the euro was approaching $1.60 dollars per euro and foreign ETFs were being driven by these foreign currency gains. During that time, we questioned the strategic role of currency risk, the modus operandi of practically the entire U.S. investing population when they invest in foreign equities abroad. In fixed income, it is par for the course to assume an investor hedges currencies in developed world fixed income. Why would you take FX volatility that swamps fixed income asset-class volatility? But equities are more volatile, so investors tend to rationalize that they can withstand a few extra percentage points of annualized volatility because perhaps they believe currency can be a “diversifier.” We challenged this assumption. Instead, we championed the view that developed world currencies offer “uncompensated risk”—or higher expected risk for zero gains in expected returns for U.S. investors. Sometimes currency helps; sometimes currency hurts. It may wash out in the end, but if it adds to your volatility profile, why should U.S. investors assume that currency risk? We started offering the first currency-hedged ETFs in late 2009 and have continued to expand, offering a focus on Europe, Japan and multiple currency baskets from the developed world, including spaces such as international small caps with DLS.   Same Strategy but Different Currency Hedges Almost 10 years after the original international small-cap ETF, we launched two more firsts and follow-ups to DLS to mitigate currency risk in two separate ways. • In 2015, we were the first firm to apply a full currency hedge to international small-cap ETFs, with a passive currency-hedged version of DLS, the WisdomTree International Hedged SmallCap Dividend Fund (HDLS). This is a version of DLS that allows investors to focus on the stock market risk and diversification offered by international small-cap equities. Note that even some of the biggest critics of currency hedging have suggested hedging currency risk for companies that have more local revenue bases. The argument was that currency volatility is more impactful for companies with a local revenue base that do not see gains in revenue from a weaker currency. International small-cap companies tend to fit this more local revenue stream base very well.   • In early January 2016, WisdomTree launched a set of Funds that incorporate a dynamic element to the management of currency risk. This dynamic version of DLS is the WisdomTree Dynamic Currency Hedged International SmallCap Equity Fund (DDLS).   Status quo bias is hard to overcome, and investors have largely kept unhedged exposures—except in cases such as Europe and Japan where they have largely been expressing specific views on the euro and yen. But I encourage investors to rethink their framework and question why they want to bet "that" a broad basket of foreign currencies in unhedged strategies will forever and always appreciate against the U.S. dollar.   Looking Forward: A Factor Approach to Dynamically Adjust Hedges It is clear that over last five years, hedging currency risk would have improved the returns of international equities. But how can investors proactively determine whether they want that currency risk looking forward? Our dynamic strategies incorporate the most important factors and determinants of exchange rate movements. Those three factors are interest rate differentials, momentum and value. You may have heard the phrase “value and momentum everywhere.” In our view, those two factors help explain currency moves. Our Index process, developed in conjunction with Record Currency Management, added interest rate differentials (or carry) to value and momentum, as interest rates are also known to drive currency gains. At the very least, by not hedging currencies that can be expensive to hedge because of a high carry cost (as is now the case in Australia), you can potentially turn the cost of hedging from paying carry to your favor by hedging only when you are paid to do so (as you are today in the euro, yen and Swiss franc, through positive interest rate differentials). In a future blog post on this topic, I will review the performance of the fully hedged and dynamically hedged international small-cap ETFs. Read more on how dynamic hedging has been working in the large-cap part of the market.     Unless otherwise noted, data source is Bloomberg.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The DDLS Fund invests in derivatives in seeking to obtain a dynamic currency hedge exposure. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Derivatives used by the Fund may not perform as intended. A Fund that has exposure to one or more sectors may be more vulnerable to any single economic or regulatory development. This may result in greater share price volatility. The composition of the Index underlying the DDLS Fund is heavily dependent on quantitative models and data from one or more third parties, and the Index may not perform as intended. The Funds invest in the securities included in, or representative of, its Index regardless of their investment merit, and the Funds do not attempt to outperform their Indexes or take defensive positions in declining markets. Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile. 

There are risks associated with investing, including possible loss of principal.  Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.  Investments in emerging markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. To the extent the Fund invests a significant portion of its assets in the securities of companies of a single country or region, it is likely to be impacted by the events or conditions affecting that country or region.   Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development.  This may result in greater share price volatility.  Dividends are not guaranteed and a company currently paying dividends may cease paying dividends at any time.   The Fund uses various strategies to attempt to minimize the impact of changes in foreign currency against the U.S. dollar, which may not be successful. Investments in derivative investments can be volatile, may be less liquid than securities and may be more sensitive to the effect of varied economic conditions.  The Fund invests in the securities included in, or representative of, its Index regardless of their investment merit and the Fund does not attempt to outperform its Index or take defensive positions in declining markets.  Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs.  Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile. 

Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time.

Diversification does not eliminate the risk of experiencing investment losses.



About the Contributor
Executive Vice President, Global Head of Research
Jeremy Schwartz has served as our Executive Vice President, Global Head of Research since November 2018 and leads WisdomTree’s investment strategy team in the construction of WisdomTree’s equity indexes, quantitative active strategies and multi-asset model portfolios. Mr. Schwartz joined WisdomTree in May 2005 as a Senior Analyst, adding to his responsibilities in February 2007 as Deputy Director of Research and thereafter, from October 2008 to October 2018, as Director of Research. Prior to joining WisdomTree, he was head research assistant for Professor Jeremy Siegel and helped with the research and writing of Stocks for the Long Run and The Future for Investors. Mr. Schwartz also is co-author of the Financial Analysts Journal paper, What Happened to the Original Stocks in the S&P 500? He received his B.S. in Economics from The Wharton School of the University of Pennsylvania and hosts the Wharton Business Radio program Behind the Markets on SiriusXM 132. Mr. Schwartz is also a member of the CFA Society of Philadelphia.