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ETFs

A Dynamic Currency-Hedged Stock Strategy

This international-stock ETF places currency bets in an attempt to enhance performance.

Currency hedging is usually an all-or-nothing decision for investors in foreign-stock exchange-traded funds. WisdomTree Dynamic Currency Hedged International Equity DDWM breaks this mold. It attempts to time its currency exposure with the help of three well-established trading signals: interest-rate differentials (carry), momentum, and value (measured by a currency's deviation from purchasing-power parity). Although this fund tracks an index, its currency overlay resembles an active quantitative strategy. Its currency bets will likely add up to a small performance edge over unhedged and fully hedged alternatives.

But this fund isn't for everyone. Its risk profile will fluctuate over time along with its hedging activity, which could make it more difficult to manage portfolio risk. And like most currency-hedged funds, it may incur higher transaction costs than its unhedged peers. Before considering this fund, it is necessary to determine whether it makes sense to hedge currency risk at all. The answer depends on the investor.

Currency fluctuations are a considerable source of risk in an international-stock portfolio. During the past decade, they accounted for nearly a fifth of the MSCI EAFE Index's total volatility. These movements tend to wash out over the long term and don't have a big impact on stock returns. Because this source of risk is not well compensated over the long term, there is a case for hedging it, especially for investors who don't have a view on currency movements.

However, there are some benefits to leaving currency exposure unhedged. It may help protect against inflation in an investor's home market, as an uptick in inflation there relative to foreign markets should cause foreign currencies to appreciate against an investor's home currency. And unhedged funds tend to charge lower expense ratios than their hedged counterparts. There are other, less obvious differences in cost. Currency hedging can increase transaction costs and reduce tax efficiency because it requires frequent trades in the currency-forward market, which can increase realized capital gains. It is also important to keep in mind that many unhedged funds have exposure to several currencies, which diversifies risk.

This fund will almost always partially hedge its currency exposure, making it riskier than fully hedged funds and less volatile than unhedged funds. It is probably not appropriate for those who decide to leave their currency risk unhedged. And it may take too much risk for some conservative investors drawn to the idea of currency hedging. But it has a good chance of offering a small performance edge to investors who take the risk.

Theory Behind the Currency Strategy The fund applies three of the most widely used themes in currency trading to time its currency exposure: carry, momentum, and value. Carry is a strategy of going long high-yielding currencies (defined by local short-term interest rates) and shorting low-yielding currencies. This is based on the well-documented violation of uncovered interest-rate parity.

Interest-rate parity predicts that investors should earn the same rate of return across all open markets because it is easy to move money across these markets. So higher-yielding currencies should depreciate relative to low-yielding currencies by an amount that offsets their interest-rate differential. To illustrate, assume interest rates are 1% in the U.S. and 4% in Australia, and that the current spot exchange rate is 1.00 AUD/USD. The expected exchange rate at the end of one year should be: Exchange rate = Spot*(1+Rf)/(1+Rd) = 1*(1+.04)/(1+.01) = 1.03 AUD/USD. (This represents a decline in the value of the Australian dollar.)

In the forward market, this is called covered interest-rate parity, and it almost always holds. If the forward rate were lower than this, like 1.01, investors could borrow in the U.S. at 1%, convert U.S. dollars into Aussie dollars at the spot rate, earn 4%, and sell forwards to hedge out the exposure. At the end of the year, the investor would convert AUD 1.04 to USD at 1.01 (USD 1.03), return USD 1.01 to the lender, leaving a USD 0.02 risk-free profit, with no upfront cash outlay.

While arbitrage enforces interest-rate parity in the forward market, spot price movements often deviate from interest-rate parity. Historically, high-yielding currencies have tended to decline in value against low-yielding currencies by less than the amount required for interest-rate parity to hold. And sometimes, they even appreciate. Therefore, carry has been a profitable strategy. But it does have some risks. It breaks down and can expose investors to large losses during flights to safe-haven currencies, which are typically lower-yielding. The profitability of the carry trade may serve as compensation for this tail risk. AQR posits an additional explanation that seems plausible: Non-profit-seeking central banks and hedgers may prevent prices from fully adjusting.

Momentum is the tendency of recent performance to persist in the short term. This phenomenon has been observed across all major asset classes. Both cross-sectional momentum, the persistence of past relative performance, and time series momentum, predicting an asset's future return from its own past return, have historically worked. Trend-following (buying or selling when price crosses a moving average) is an expression of the latter, and it is the more common momentum strategy in currencies.

One of the more compelling explanations for momentum is that market frictions cause prices to adjust slowly to new information. This could be because market participants anchor their views and underreact to new information. Hedgers may also slow price adjustments, as they take the other side of speculators' trades, who may have better information. Once a trend is established, investors may pile into the trade, or overextrapolate past results, pushing prices away from fundamental value, leading to longer-term reversals associated with the value effect.

Fundamental value in currencies is often defined by purchasing-power parity. This is the exchange rate that would equate the purchasing power of the two currencies. For example, if a Big Mac costs $4 in the United States and EUR 3 in Europe, and this is representative of the relative prices of all goods and services in the two markets, purchasing-power parity predicts that the exchange rate should be: 4/3 = $1.33 to the euro.(1) Purchasing-power parity is based on the law of one price, which states that identical goods should carry identical prices everywhere they are sold, otherwise there would be an arbitrage opportunity.

There are some problems with this theory. Not all goods and services can be easily traded across markets, like labor or retail space. Goods and services in different markets are not always identical, and even when they are, there are transaction costs to move them between the two markets. Despite these problems, exchange rates have historically moved toward purchasing-power parity over the medium to long term, though this relationship is not clean.

Currency-Hedging Application The fund tracks the WisdomTree Dynamic Currency Hedged International Equity Index, which applies a set of rules to put this theory into practice. It makes separate hedging decisions on each currency and considers each of the three signals independently, giving them each a one-third weighting in the overall hedging decision. The carry signal leaves currency unhedged when the one-month U.S. interest rate is lower than the corresponding figure in the foreign market to benefit from the yield pickup. Otherwise, it completely hedges. Because this signal receives a one-third weighting, a complete hedge on this metric translates into a 33.3% total hedge ratio. For the sake of simplicity, this signal does not take into account the magnitude of the interest-rate differentials, likely reducing its efficacy. This has been the strongest hedging signal in the index's back-tested performance.

The momentum signal is based on a trend-following rule. It hedges each currency when the exchange rate's 10-day moving average crosses below its 240-day moving average and leaves the exposure unhedged when the opposite is true. Like the carry signal, this is a binary hedge that carries a one-third weighting in the total hedge ratio.

The value signal applies a full hedge (contributing 33.3% to the total hedge ratio) when a currency is more than 20% overvalued based on purchasing-power parity and no hedge if the currency is more than 20% undervalued. When a currency falls between these two extremes, this signal maintains a 50% hedge (contributing 16.7% to the total hedge ratio). This was the weakest signal in the back-test, which isn't surprising given some of the frictions that may prevent purchasing-power parity from holding in practice. The fund's benchmark then adds up the hedges from the three signals to determine the total hedge ratio for each currency and rebalances monthly.

These rules are simplistic and may not be the optimal way to implement a dynamic currency hedge. But they capture the essence of carry, momentum, and value and should modestly help performance if those effects persist, as I believe they will.

Underneath the currency hedge, the fund offers the same portfolio as WisdomTree International Equity DWM (0.48% expense ratio), and yet it charges a lower 0.35% expense ratio, suggesting that the former is overpriced. The portfolio includes large- and mid-cap dividend-paying stocks listed in developed markets overseas. It weights its holdings by the value of their dividend payments, which is a form of fundamental weighting that causes the fund to rebalance into stocks as they become cheaper relative to their dividends.

Summary There is solid theory and empirical evidence to support carry, momentum, and value currency trading. The fund's simplistic currency trading rules may not be optimal, but they should help performance if these effects continue. Its reasonable fee and well-diversified value-oriented portfolio add to its appeal. But this strategy isn't appropriate for investors who want to mitigate currency risk, as it will almost always be partially unhedged.

(1) This example borrows from The Economist's "Big Mac index."

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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