WisdomTree And Currency Hedging
WHAT IS CURRENCY HEDGING?
International investing provides many exciting opportunities for investors:
- The potential to go up when the U.S. market is down
- Exposure to different trends, opportunities—and risks
- The potential for higher returns given relative valuations
But these opportunities come with additional risks—one of which is currency fluctuations. While currency can sometimes push equity returns higher, it can often pull returns down—and these fluctuations are typically a source of uncertainty.
Currency hedging is a strategy designed to mitigate the impact of currency or foreign exchange (FX) risk on international investments returns. Popular methods for hedging currency are forward contracts, spot contracts, and foreign currency options.
It enables investors to target local equity returns of international markets—and it may be simpler and more cost effective than you think.
WHY HEDGE CURRENCIES?
The ABCs of Currencies
Currency can be a headwind—or a tailwind
Imagine you’re on an airplane heading from New York to Los Angeles. The jet stream, which flows from west to east, is creating a headwind that slows down the airplane and makes the flight take about 6½ hours. Your return trip, however, will only take about 5½ hours, because the jet stream now acts as a tailwind that helps propel the plane forward. Currencies are exactly the same. Sometimes they are the tailwind helping push the security forward, and sometimes they are the headwind holding it back. But either way, they always make the ride more turbulent.
CURRENCY IMPACTS YOUR U.S. DOLLAR INVESTMENT
Even the most sophisticated investors can wonder why currency is affecting them if their investment is in U.S. dollars. If you’ve ever traveled abroad, you know that sometimes your dollar buys more, and the goods you purchase seem inexpensive—and sometimes the opposite is true. This is because of fluctuations in the strength of the dollar compared to the currency of the country where you are purchasing goods or making investments. These types of currency differences can impact the value of your investment over time.
CURRENCY CAN BE HARD TO PREDICT
Because currency may move in waves, trending one way or the other, it can significantly impact your investments over certain periods. Predicting which way it will go, especially in the short term, is practically impossible for investors.
Sources: MSCI, Bloomberg, 12/31/16
CURRENCY ADDS VOLATILITY — AND THAT CAN BE COSTLY
A portfolio's average annual returns are important—but they do not tell the full story. In the example below, portfolios A and B both start out with $500,000. Although it may not look like it, they both have average annual returns of 10%. After five years, however, portfolio A is worth just over $804,000, while portfolio B is worth less than $772,000. Why? Volatility.
VOLATILITY CAN COST YOU TIME
Volatility can cost you not only money, but time as well. In fact, the more your portfolio drops, the higher a return you will need and the longer it could take to get you back to where you were. For example, a drop of 30% will take six years to recover from at 6% per year, nine years at 4%, or nearly 18 years at 2%. And that is simply to break even. If you want to get ahead, you need to earn much higher returns or spend even more time.
FULLY HEDGED EXPOSURE
Fully hedged ETFs are designed to mitigate the currency exposure from an investment, regardless of market conditions. While this may impact returns positively or negatively, it can reduce overall volatility—and that can be critical for portfolio values.
At WisdomTree, we have been implementing currency-hedging strategies in a way that is likely simpler and more cost-effective than many investors expect.
Our full currency hedge works like this:
The WisdomTree currency-hedged equity family of Funds implements WisdomTree’s currency-hedging strategies by entering into one-month forward contracts each month and rebalancing at month-end.
WisdomTree CURRENCY HEDGED EQUITY FAMILY
Not only are many of the world's leading companies—and familiar brands—headquartered in Europe, but they are truly global companies that generate the bulk of their revenue from exporting to countries outside Europe. Our family of European hedged equity Funds offers investors a way to more fully access the return potential of European equities while hedging the effects of the currencies.
Asian investments can be a smart addition to a portfolio, and now may be an opportune time to add Japan, as this country is undergoing exciting changes.
However, history has shown that in export-driven economies, the equities typically go up when the currency is going down. That can erode investors’ returns. Hedging the yen can help reduce volatility.
International investments should have a place in every portfolio, and now may be an opportune time to add them.
Of course, we believe that international equities tend to perform better when the U.S. dollar is strengthening—and if history repeats, we may be on the cusp of a prolonged period with a rising dollar. If the dollar is rising, other currencies are often weakening. Hedging them can help reduce volatility.
TODAY'S INVESTORS HAVE CHOICES
Today’s investors can offset currency risk with fully hedged ETFs, or they can attempt to opportunistically capitalize on it with dynamically hedged ETFs.
Full currency hedging is designed to mitigate currency exposure, helping reduce volatility and provide the equivalent of local returns. But what if you are interested in capitalizing on currency when it can help your returns? It can be very challenging for investors to determine when and how much to hedge.
Dynamic hedging can help solve these challenges—using rules-based processes based on sophisticated signals to determine the right time to hedge and how much to hedge.
Dynamically hedged ETFs attempt to determine the best times for a portfolio to be hedged. Depending on market conditions and specific quantitative indicators, these strategies automatically dial the currency exposure up or down. This may provide investors with the potential to opportunistically capitalize on currencies when they may help returns—and to avoid them when they may not.
The WisdomTree dynamically hedged ETFs use rules-based methodologies and a proprietary signal overlay to determine the potentially best times (and amounts) to be hedged, or not to be hedged, automatically dialing the currency exposure up or down given specific signals.
THE THREE SIGNALS WE BELIEVE CONTRIBUTE TO EXPLAINING CURRENCY TRENDS
|Indicator||Description||Hedges Currency If|
|Momentum||Sensitivity to how a foreign currency tends to trade against the U.S. dollar||The foreign currency us experiencing a downward trend|
|Interest Rate Differential (aka "Carry")||The difference between the one-month forward interest rate of a foreign currency and the U.S. dollar||The interest rate of the foreign currency is lower than that of the U.S. dollar|
|Value||Using the concept of purchasing power parity to define a measure of relative value for a foreign currency against the U.S. dollar||The foreign currency is "expensive" compared to the U.S. dollar|
These signals are equally weighted at one-third each in terms of contribution to the overall hedge ratio, with one signal able to indicate a “half-hedge” of 16.67%. As a result, dynamic portfolios can be hedged