Dynamic Currency Overlay: What’s Behind the Signals?
with research from Andrew Bloomfield of Record Currency Management
WisdomTree has worked with Record Currency Management (Record) to use its currency research and currency signals to help support dynamically hedging currency exposures within international equity strategies. In international investing, currencies can contribute a significant portion of overall returns and volatility, making exposure to currency an important factor driving international results. Record’s research finds that there are a number of fundamental factors that capture the sources of return inherent in the currencies of developed markets. The dynamic currency overlay distills these factors into a set of signals used to adjust hedge ratios up or down, according to the anticipated likelihood of international equity exposure currencies depreciating or appreciating.
Setting hedge ratios in this manner means retaining high hedge ratios when the exposure currencies are expected to depreciate, and lowering hedge ratios when exposure currencies are expected to appreciate. This is intended to allow investors to help protect against currency losses, while participating in foreign currency gains, to the extent the currencies perform within these expectations.
For any individual currency, hedge ratios can be adjusted between 0% and 100% based on the results of three commonly-accepted signals as researched by record:
- Carry (interest rate differentials or the cost of hedging): the observation that higher interest rate currencies tend to outperform low interest rate currencies
- Momentum: Momentum is the tendency for the spot rate to appreciate following prior appreciation.
- Value: The value factor seeks to profit from the mean-reverting nature of exchange rates at longer time horizons around “fair value,” as measured by purchasing power parity (PPP).
Combined, these signals inform currency hedge ratios, depending on where a currency is in its cycle, how expensive it is to hedge and the current trajectory of the currency.
Active Signal Weights and the Factors Considered
WisdomTree incorporates the hedge ratios into models that underpin certain actively managed WisdomTree exchange-traded funds (ETFs), such as the WisdomTree International Multifactor Fund (DWMF). The hedge ratio weights are determined on a currency-by-currency basis through an assessment of the relative strength of these three signals, the underlying macroeconomic environment, broad market positioning and imbalances and other technical considerations that could be expected to alter the effectiveness of any given signal. In effect, hedging signals for which there is a higher level of conviction are given a greater weight.
Current Signal Positioning
Across the currencies within this framework,1 hedge ratios are higher than would be the case under equal weights for all currencies except the Swiss franc (which is already 100% hedged under equal weights). These higher hedge ratios reflect a greater allocation to the carry and momentum signals (which both have hedges switched on) and a relative underweight to the value signal (which has lower overall hedge ratios). The discussion below provides more color behind these weightings, including through research from Record.
U.S. economic activity remains robust compared with other developed markets, likely helped along by tax cuts and still accommodative financial conditions. Accordingly, the Federal Reserve is well into its rate hiking cycle while other central banks maintain comparatively easy monetary policy. This has created an attractive interest rate differential that is earned by U.S.-based investors who are hedging currency risk. It appears that this interest rate differential is currently enhanced by a market anomaly called the “cross-currency basis” whereby U.S. interest rates on forward foreign exchange contracts exceed those in money markets; it reflects a supply shortage of U.S. dollars and equally represents an opportunity for U.S.-based hedgers to supply liquidity to the market.
The same factors creating interest rate hedging tailwinds have created currency momentum in the U.S. dollar, which has been appreciating on a trade-weighted basis since April. The momentum signal may to be adequately tracking relative economic cycles, and may likely to adjust if there is a sudden change in market positioning, a reversal in the economic cycle or a multimonth, risk-driven move in the U.S. dollar.
Over time, monetary policy in different countries can diverge, which may cause terms of trade shocks and other external drivers of momentum to cause overshooting of exchange rates from their fair values. While the interest rate opportunity is universal across exposure currencies, value opportunities seem more mixed. The euro, yen and British pound appear undervalued, while the Australian dollar and Swiss franc may be overvalued.
Only in the euro exposures does there appear to be a value opportunity following the currency’s politically driven decline over the summer. The Swiss franc is substantially overvalued on a PPP basis; however, Record’s research shows the need to account for high Swiss productivity rates, which makes PPP a less conclusive signal empirically. In the British pound, a lower value allocation leads to an increase in the hedge ratio which might be beneficial given current uncertainty as the Brexit deadline approaches.
Dynamic Currency Overlay
A Multifactor ETF
As noted above, the WisdomTree International Multifactor Fund is one of the models-based, actively managed ETFs available from WisdomTree that incorporates this more active currency signal. Instead of creating multiple currency versions from unhedged to fully hedged to dynamically hedged, in this new multifactor international strategy, WisdomTree wanted to create one option that incorporated what WisdomTree believes is a best of breed for this type of strategy: including the currency factor as one of the multiple factors of the ETF. WisdomTree’s research, including that of Record, leads WisdomTree to believe this dynamic currency factor can both increase returns over the unhedged and fully hedged strategies and reduce volatility compared with unhedged strategies. This dynamic currency factor also makes DWMF unique among the international, multifactor range of today’s ETFs.
1Euro, Japanese yen, British pound, Australian dollar and Swiss franc.
Important Risks Related to this Article
Investing involves risk including possible loss of principal. Investments in non-U.S. securities involve political, regulatory and economic risks that may not be present in U.S. securities. For example, foreign securities may be subject to risk of loss due to foreign currency fluctuations, political or economic instability or geographic events that adversely impact issuers of foreign securities. Derivatives used by the Fund to offset exposure to foreign currencies may not perform as intended. There can be no assurance that the Fund’s hedging transactions will be effective. The value of an investment in the Fund could be significantly and negatively impacted if foreign currencies appreciate at the same time that the value of the Fund’s equity holdings falls. While the Fund is actively managed, the Fund’s investment process is expected to be heavily dependent on quantitative models, and the models may not perform as intended.
Please read the Fund’s prospectus for specific details regarding the Fund’s risk profiles.
No WisdomTree ETF is sponsored, endorsed, sold or promoted by Record, and Record makes no representation or warranty, expressed or implied, to the owners of these Funds regarding any associated risks or the advisability of investing in the Funds. Record provides certain research and information to WisdomTree and has licensed certain rights to WisdomTree, but Record is providing no investment advice to any WisdomTree ETF.