Managing Currency Risk in a Systematic Fashion

Despite fears of a collapsing U.S. dollar fueled by high inflation levels, the dominating driver for currencies has been an aggressive Federal Reserve hiking rates, while central banks from Europe and Japan have been slow to remove their accommodation. The Bank of Japan (BoJ) has rather aggressively defended capping its long-term bond yields, which has sent the yen downward as a growing gap exists between U.S. Treasuries and Japanese government bonds (JGBs).  

The Dollar: A Hedge on Risk

The dollar has been one of the most negatively correlated assets to the S&P 500 over the last 12 months—and also the last decade—and the evidence questions the merit of assuming foreign currency risk when investing overseas. I recently wrote a note on the benefits of being neutral on foreign currency risk due to the declining diversification properties of weak dollar bets.

For the most recent standardized performance click here.

Dynamic Hedging

There is also a middle ground between a completely hedged and unhedged approach.

Six years ago, WisdomTree launched a suite of dynamically hedged currency ETFs, and the track records of these systematic hedging strategies have been quite impressive, in my view. This family incorporates currency signals across momentum, interest rates and currency valuations to determine a hedge ratio on every currency.

The current aggregate hedge ratios are approximately 63% for the basket and range from a low hedge ratio of 50% for the Australian dollar to 100% hedged for the Swiss franc. The euro and yen are both two-thirds hedged—based on the combination of interest rate and momentum signals, while the valuations of those currencies are “cheap” on a purchasing power parity basis, that segment of the signals is unhedged, for one-third of the total hedge ratio.

We have a broad international value strategy and international small-cap strategy with this dynamic hedge feature. Both strategies on an unhedged basis have 16-year histories that were part of the original 20 dividend ETFs WisdomTree launched in 2006.

The WisdomTree Dynamic Currency Hedged International Equity Fund (DDWM) has received a five-star rating from Morningstar (overall rating as of 7/31/22 based on risk adjusted return out of 315 funds in the Foreign Large Value category), while the small-cap version, the WisdomTree Dynamic Currency Hedged International SmallCap Equity Fund (DDLS), has a four-star rating (overall rating as of 7/31/22 based on risk adjusted return out of 57 funds in the Foreign Small/Mid Value category). See our Morningstar ratings page for more info.

The stars are a quick way of summarizing these strategies as having delivered strong risk-adjusted returns, and there is a good emphasis on the risk-reduction properties that come with the dynamic currency hedge.

Since we launched DDWM in 2016, the MSCI EAFE Value Index has been riskier than the MSCI EAFE Index.

By contrast, our dynamic currency-hedged DDWM has displayed lower risk than the MSCI EAFE Index. We can illustrate this risk reduction in two ways:¹

1. Beta: Since Fund inception, the MSCI EAFE Value Index has had a higher beta relative to MSCI EAFE, while DDWM has a beta of 0.83.

2. Standard Deviation: The MSCI EAFE Value Index had a two-point higher standard deviation relative to MSCI EAFE, while DDWM was nearly two points lower, again since Fund inception.

The dynamic currency hedge contained in DDWM—when compared to the same basket of equities without the currency hedge (available via the WisdomTree International Equity Fund (DWM))—added almost 200 basis points per year over the last six years.

The currency hedge value-add to returns was high over this period, but the risk reduction is what we would expect on a longer-run basis.

For the Fund’s full standardized performance and other important information, click the respective ticker: DDWM, DWM.

Over the last decade, the U.S. markets have strongly outperformed international stocks—some of it was tied to the Technology sector dominating U.S. markets—while global markets have more value-tilted exposures and sector biases. Another factor is currency fluctuations and a stronger dollar hurting unhedged strategies that relied on weak dollar bets.

WisdomTree’s dynamically hedged currency family can help access the low valuations of foreign markets but with a strategic approach to managing currency risk.

¹ Source: Zephyr StyleADVISOR, as of April 30, 2022. Past performance is not indicative of future results. Subject to change. You cannot invest directly in an index.