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By Alex Bryan, CFA | 09-07-2017 11:00 PM

Hedge Your Currency Risk When Investing Abroad

WisdomTree's director of research, Jeremy Schwartz, says investors should hedge out at least part of their foreign currency risk.

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Alex Bryan: For Morningstar, I'm Alex Bryan. We're here at the 2017 Morningstar ETF Conference where I'm joined by Jeremy Schwartz, who is the director of research at WisdomTree.

Jeremy, thank you for joining me.

Jeremy Schwartz: Thanks for having me, Alex.

Bryan: Jack Bogle has made the argument that U.S. investors don't necessarily need to venture outside the U.S. market to get global exposure because most large-cap U.S. stocks have global businesses and yet foreign stocks have greater currency risk than U.S. stocks. And over the very long term you would expect different markets to offer similar rates of return. He argues that given the higher risk and similar returns coupled with the fact that U.S. investors already have a lot of global exposure, you shouldn't go outside the U.S., or it's not necessary to go outside the U.S. Would you agree with Jack Bogle?

Schwartz: I think you absolutely can get a globally diversified revenue profile from the U.S. They do have half their revenues across the world. But the question is, forward-looking returns--how do the U.S. compare to some of the foreign markets? And valuations do have an impact on future returns.  I would disagree. I think investing in only half the opportunities around the world, and the U.S. is only half the world's market cap, you are missing half the opportunities. And if these other half of the opportunities are priced cheaper, it can be a better forward-looking return. I would say, you should be invested globally. He did mention that foreign companies have higher risk because you have to take currency risk, which I don't think is true. You can now strategically hedge currencies in a much easier way than you could years ago and that can lower your volatility profile and argue for even more allocations internationally if you take out that currency risk.

Bryan: Let's talk about that currency hedging component. How should investors decide whether or not it makes sense for them to hedge their currency risk? What's the trade-off between hedging and not hedging?

Schwartz: The trade-off is, I call currency uncompensated risk, that when you are going overseas you have to take two bets--so you have your stock risk and then you have your currency risk. The question is, are you compensated to take that? And I say, you are going to take stock risk versus bond risk but there is no model that says the euro will always go up. So, you can lower your risk profile. The data shows convincingly you have a lower volatility when you just focus on the stocks alone.

And so, you could say, if I want to get a lower volatility, I want to increase my international, get that lower volatility. That's the case for strategically hedging. Now, the question is, looking backward one will always do better than the other. So, the questions is, should you be fully hedged, fully unhedged, or something in the middle, half-hedged? Some people call that like your minimum regret portfolio because one will always be better in hindsight with foresight much harder and you get about three quarters of volatility reduction by being half-hedged. So, that's one starting point. But then again, the question is, can you do better or worse than that from there.

Bryan: What would you recommend, a fully hedged portfolio, a 50-50 hedged portfolio?

Schwartz: The one thing I'd suggest not doing is being unhedged all the time. I'd say I can argue for strategic hedging to lower your volatility profile. WisdomTree recently focused on dynamic hedging where we are trying to add value with a currency factor model looking at value, momentum, and carry, a three-factor currency model that will raise and lower the hedge ratio. Today that model is roughly 40% hedged, a third on the euro, half on the yen, half on the pound. So, we adjust dynamically based on those three factors. It's going to be hedged for a long time on interest rates. The Fed is raising rates. The ECB is negative. Value--some of these currencies start to look a little cheap but most are not super-cheap. And momentum moves around. So, the hedge ratio came down as these currencies started to depreciate. It's a dynamic model. We think that can add value, 100 basis points over time, is our belief.

Bryan: Right. So, your argument is that by hedging the currency risk you can reduce the volatility without having a material impact on your expected returns going forward so you can improve your risk-return profile?

Schwartz: That's the case for always hedging, that there is no added return profile from being long on the currencies. So, hedging, you lower your risk profile. And then dynamically hedging is, you look to add value on top of that if these currency factors are rewarded.

Bryan: Let's talk about the cost of hedging. In foreign developed markets it appears that the cost of hedging is low but the cost of hedging might be higher right now in emerging markets. Could you talk about how the cost of hedging should influence your decision of whether to hedge or not to hedge?

Schwartz: Very important question. When I'm making blanket statements, I believe in hedging strategically to lower your volatility profile and that would be true in the emerging markets, but it's a very high cost in emerging markets. And I think it's actually prohibitively high cost today for the emerging markets. That may change in the future. But today, when I talk about hedging, I talk about the developed world. And there it's really a better than free option from the, how much you are paid to hedge from an interest rate perspective. The Fed is at 1% plus. The ECB is at negative 40 [basis points]. You are paid over 1.5% if the euro does nothing. So, there is actually a net credit from hedging, which is why when foreign fixed-income people, they don't have to get negative yields in Japan. They actually get a positive yield by hedging the yen because they are paid that net difference in the yen.

Bryan: And what's driving those differences in costs to hedge across different markets?

Schwartz: It's just the central bank interest-rate policies. The Fed is at 1% and the ECB at negative 40 [basis points]. If you're going to guarantee an exchange rate ... so, think about Brazil. You can move all your money to Brazil and earn 10%. Now, if you want to guarantee your exchange rate one month from now, how are they going to price that guarantee? They are going to guarantee it based on the fact that you could earn 10% in the local money market. You have got only 1% here. So, that difference between 1 and 10 is how they will price the guarantee for one month from now. So, that's how forward contracts work, that's how you hedge using forwards in equity ETFs and fixed-income ETFs. It is all priced with that idea that there is no arbitrage, you can't be able to just move all your money to Brazil and guarantee yourself an exchange rate one month from now.

Bryan: Investors should definitely invest globally and they should hedge out at least part of their foreign risk.

Schwartz: That's a big part of what I talk about. There's better opportunities value-wise--Japan, Europe, cheaper than the U.S., but I can't say I'm very bullish on the yen, very bullish on the euro. I'd say at least 50% hedged, but maybe dynamically, if you think these currency factor models can add value.

Bryan: Great. Interesting insights. Thanks for sharing them with us.

Schwartz: Thanks, Alex.

Bryan: For Morningstar, I'm Alex Bryan.

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