Emerging markets (EM) have traditionally had higher interest rates than the U.S. While hedging can reduce risk, it also comes with a significant cost, diminishing the benefits a U.S. investor can reap from hedging.

Consequently, we propose dynamic currency hedging in emerging market portfolios as a potential solution. This approach has been incorporated into our Emerging Markets Multifactor strategy (EMMF).

In the last 20 years, the U.S. dollar has seen an increase in value compared to most currencies. This implies that a completely hedged emerging market portfolio could, in theory, provide greater returns and significantly less volatility. However, the process of fully hedging an emerging market portfolio can be expensive. Often, the additional benefit from local return as compared to the dollar return is insufficient to offset the cost of hedging.

Figure 1: MSCI Emerging Market Index Local and Dollar Returns

While the U.S. generally has higher interest rates than developed countries in Europe and Japan, allowing U.S. investors to earn carry from hedging these currencies, this is not the case for many emerging market economies. For instance, it was only when the U.S. significantly raised interest rates that a U.S. investor could be paid for hedging major EM currencies, such as the Chinese yuan.

Take India as another example—a country with historically higher interest rates than the U.S. This typically means that U.S. investors are expected to pay to hedge, as the hedging carry is usually negative.

Figure 2: Annualized Carry of Major Emerging Market Currencies

Considering the cost of hedging emerging market currencies, we’ve developed a currency model based on multiple factors, such as momentum, low volatility and the impact of equity markets on currencies.

The hedge ratio for the overall portfolio and each individual currency can range from 0% to 100%. Since its inception in 2018, EMMF's portfolio has been approximately 36.4% hedged, which substantially reduces hedging costs.

At present, the EMMF portfolio is hedged at 91%, and the average year-to-date hedging is at 51%. Despite the portfolio being nearly fully hedged currently, the cost of hedging is almost negligible. This is primarily because we are currently receiving payment for hedging currencies from China, Taiwan and South Korea because of the higher U.S. interest rate.

Figure 3: Dynamic Currency Hedge Ratios Used in the WisdomTree Emerging Markets Multifactor Strategy

In our WisdomTree Emerging Markets Multifactor Fund, we employ multifactor methods for both equity and currency hedging. The past five years have been challenging, as mega-large cap and momentum have dominated investor attention. However, for patient investors, factor-based strategies have yielded similar or superior results with significantly less volatility.

Figure 4: The WisdomTree Emerging Markets Multifactor Strategy (EMMF) Has Delivered Lower Volatility and Higher Return over the Last Five Years

For the most recent month-end and standardized performance, click the respective ticker: EMMF, XSOE, XC, DGRE.

When discussing an emerging market portfolio, China is an inevitable subject. In addition to currency hedging to mitigate risk, we’ve also reduced some China exposure in the EM multifactor strategy due to the current economic slowdown in China and clients’ preferences for partial rather than full China weight.

We now offer a variety of strategies, ranging from 0% China exposure in DGRE and XC to full China weight in an emerging market portfolio like XSOE and DGS or partial China exposure like EMMF.

Figure 5: A Range of Emerging Market Strategies at WisdomTree, from 0% China to Full China Weight

Emerging market portfolios, whether excluding China or not, still have lower valuation and leverage and higher quality than the benchmark, particularly multifactor-based strategies such as EMMF and DGRE.

Figure 6: Factor Portfolios Have Lower Valuation, Lower Leverage and Higher Quality

For the most recent month-end performance, prospectus and 30-day standardized yield, click the respective ticker: EMMF, XSOE, XC, DGRE.

In conclusion, we believe that there’s a balance to be struck between hedging some emerging market currencies and the high cost of hedging. We’ve implemented a factor-based dynamic currency hedging model in our emerging market multifactor strategy that could serve as a risk-mitigated starting portfolio.