I have been focused on the opportunities presented by international stocks in some of our latest research. After a decade of U.S. equity market outperformance, it may be time for the developed world to outperform over the next decade. Once one decides to allocate more weight to international stocks, there are a number of important follow-on questions on implementation: Should one invest by region, tilt weight to various size segments, take foreign currency risk?
I have previously profiled three versions of our international small-cap dividend strategy. The main idea: Ten years ago WisdomTree introduced the first international small-cap ETF in the U.S., but in the last two years we launched versions that offer a passive currency hedge to neutralize currency impact, and in 2016 a more dynamic process that aims to add value by adjusting the hedge ratio based on a multi-factor, dynamic hedging process.
We have nine months of real-time results for this international family of dynamically hedged ETFs, and we can evaluate how they’ve done during a period of perplexing currency moves and volatility.
Below we show the results for the WisdomTree Dynamic Currency Hedged International SmallCap Equity Fund (DDLS) compared to the MSCI EAFE Small Cap Index in local currency and in U.S. dollars, along with fully hedged and unhedged versions of the same WisdomTree strategy.
International Small-Cap Equity Cumulative Returns (1/7/16–9/30/16)
2016 has been a year when dividend weighting has helped add value over traditional market cap weighting. On an unhedged basis, the WisdomTree International SmallCap Dividend Fund (DLS) has outperformed its benchmark by over 200 basis points (bps).1
In a year where unhedged strategies have beaten the local market returns by almost 5 percentage points, the dynamic currency-hedged version (DDLS) has been able to almost keep pace with the unhedged strategy and outperform the local EAFE small-cap market return by over 550 basis points since its inception. This is showing value from adding currency exposure compared to the pure local market return, while helping to protect from the fall in value of one currency in particular: the British pound (GBP).
Hedged GBP: Our hedge ratio on the GBP has been 83.3% since 12/28/15, and this helped protect returns following the post-Brexit GBP collapse. Why did the dynamic process have an 83.3% hedge for the GBP heading into Brexit? The momentum and interest rate signals have both suggested a hedge for the GBP since the U.S. hiked its rates in December and U.S. investors were being paid a marginal amount to hedge the GBP, while the value signal has suggested a half-hedge. The GBP’s decline in 2016 was one of its larger drops in history, and it is important to see that our hedging process was able to blunt the impact of its decline quite effectively—the exact goal of a hedging strategy.
Gains in Currencies Such as the Yen: While passive currency-hedged strategies could have been better served by being 100% hedged on the GBP—instead of the 83.3% of the dynamic model—dynamic hedging outperformed these hedged strategies so far in 2016, in large part because the yen has appreciated this year and dynamic hedging incorporated a 50% hedge ratio on the yen since late 2015, when the yen’s momentum rolled over.
Trend Toward FX Hedging Equities Still in the Early Innings
Reiterating one of our core beliefs, in our view, developed world currencies offer higher expected risk levels with no expected return enhancement. Why would you accept these higher risk levels, unless you are good at timing when you want currency risk to be unhedged?
Adopting a dynamic approach with WisdomTree moves you away from subjective calls and into a disciplined, “smart beta” and factor approach to currency risk management. We believe our factors (“carry,” “value” and momentum”) bring potential to outperform both hedged and unhedged strategies over time by rotating currency hedges with their cycles.
DLS itself has a strong 10-year track record of delivering value added over its benchmark and peers in an unhedged format. With these latest additions, investors can target international exposure with increasing sophistication, and we think with prospects for a better risk/return experience over time.
1Source: Bloomberg, as of 1/7/16–9/30/16.
Important Risks Related to this ArticleThere 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.