Is Your Mutual Fund Manager Managing Currency Risk?

In January, WisdomTree surveyed nearly 200 advisors to find out how many delegated the decision to hedge foreign currencies to an international fund manager. Nearly 7 in 10 replied that they did. Making decisions on when to take on currency exposure–or to mitigate its impact—is not easy. Thus, many financial advisors, investment firms and investment committees choose to outsource that decision to an active manager. That raises two interesting questions: Have active managers been hedging foreign currencies? And if so, how have they done? The past five-year period is a useful window to examine these questions, because it coincides with one of the most visible U.S. dollar rallies of the past four decades. From early August of 2011 through January 22, 2016, the latest date with available data, the U.S. trade-weighted dollar has surged 40% on a cumulative basis against the currencies of America’s major trading partners. As shown in the table below, surely if active managers had been managing the risk that depreciating foreign currencies pose to their clients’ portfolios, we would have noticed it over this period. Managers who had mitigated currency risk would climb in the “league rankings” and would have matched or surpassed the returns generated by the MSCI EAFE 100% Hedged to USD Index, which mitigates the impact of currency. Those that did not hedge currency, or hedged in an ineffective manner, would have had to exhibit extraordinary stock picking prowess to make up for the huge headwind created by being on the wrong side of the dollar’s ascent over this period. Since June of 2014, the annualized difference between owning a basket of MSCI EAFE Index stocks hedged versus unhedged has amounted to nearly 11 percentage points per year. So how did the active mutual fund managers do? We ran screens to help answer that question. We identified all the international equity funds characterized by Morningstar as “Foreign Large Value, Foreign Large Blend or Foreign Large Growth” and analyzed their returns over the trailing one-, three- and five-year periods to see how they performed against the MSCI EAFE 100% Hedged to USD Index.   The MSCI EAFE 100% Hedged to USD Index beat 95% of the active managers over the last year, 100% over the last three years, and 98% over the last five years. This tells us, indirectly, that the vast majority of active managers have not been managing the currency call. In fact, when we searched for the best-performing open-end fund over the last year, we found that it was a WisdomTree exchange-traded Fund, the International Hedged Quality Dividend Growth Fund (IHDG), which actually beat the MSCI hedged benchmark, and more than 1,400 mutual funds in the process. So why didn’t more active managers manage foreign currency risk more effectively over this period? We think some didn’t because they don’t believe, philosophically, that hedging currency adds value over time—even if there may be seven- or eight-year periods when currency moves can work for or against them. Some didn’t because they believe there is a cost to hedging that works against them. Though this may be true in certain periods, today the cost of hedging in the developed world is virtually nil, and over the last 30 years, the differential in interest rates between the foreign currencies within MSCI EAFE Index and the U.S. dollar has actually favored U.S investors. Some active managers may not hedge currencies because they are more comfortable making stock calls rather than currency calls. And many are benchmarked against unhedged indexes, and so, for them, hedging a currency is an active decision they may not wish to make. But in a world at risk for deflation, making a permanent bet against the dollar—which is what 100% unhedged positions do—may not be in investors’ best interest. Increasingly, advisors are making the decision for themselves. In just a few years, the percentage of the $360 billion invested in developed world equity ETF assets that hedge out currency has increased from virtually 0% to roughly 17%. But with the vast majority of active international mutual funds (representing more than $1 trillion in assets under management) still predominantly unhedged, the migration into 100% hedged or dynamically hedged strategies may still lie ahead. For those who delegate the decision to an active manager but are disappointed with their ability to do so effectively, WisdomTree has created a family of hedged currency Indexes and dynamically hedged currency Indexes that make the decision regarding when and how much to hedge for you. WisdomTree’s underlying Index for IHDG mitigates the risk of currency exposure each month. Dynamically hedged indexes have the ability to rebalance the currency exposure each month based on three signals: momentum, interest rate differentials and relative value between currencies, ranging from 0% hedged to 100% hedged based on purchasing power parity.     Learn more about WisdomTree’s approach to dynamic currency hedging in the developed world. Unless otherwise notes, data source is Bloomberg, as of 1/31/2016.