This International Growth Fund Screens for Quality and Hedges Currency Risk

WisdomTree International Hedged Quality Dividend Growth Fund IHDG emphasizes dividend-paying stocks through its dividend-weighted approach. The fund also screens for profitability and earnings growth, which increases its likelihood of holding stocks that will maintain or grow their dividend payments. Despite this reasonable approach, the fund’s short history and its high fee compared with alternatives limit its Morningstar Analyst Rating to Bronze.

The portfolio targets 300 developed-market stocks that score high on various measures of quality including: long-term estimated earnings growth, return on equity, and return on assets. The emphasis on these metrics tilts the portfolio toward companies with more durable competitive advantages, and causes the fund to have a growth orientation. Almost 94% of the companies in this portfolio have a wide or narrow economic moat, which is among the top decile in the Foreign Large Growth Morningstar Category. The fund’s return on invested capital and return on equity also land in the top decile of the category.

Stocks are weighted based on total dividends paid over the previous twelve months. This approach overweights stocks that have declined in price relative to dividends paid and away from those that have become more expensive. This contrarian methodology can cause turnover to be higher than a market-cap-weighted approach, and emphasizes stocks with high dividend yields. Currently this fund’s yield lands in the highest decile of the category.

This fund also hedges its currency risk using currency forward or futures contracts, which has aided the fund’s performance over the past several years as the dollar has been strengthening relative to many other currencies. Although it has a short history, its annualized return over the past three years through May 2017 was better than 97% of its peers, and volatility was in the lowest decile of the category. Over long periods of time, hedging currency risk can reduce the volatility associated with fluctuations in foreign exchange rates. The majority of the funds in this category do not hedge their currency risk.

Fundamental View

Strategies that emphasize dividend-paying stocks can offer investors some tangible benefits. Regular dividend payments can help investors stay invested through market downturns. Firms that provide stable dividend payments can also help investors better forecast income. Dividends can also be used to signal a company’s financial strength, making corporate managers hesitant to reduce dividend payments. Additionally, dividend payments reduce the cash available for a firm to pursue investment activities. This can instill a sense of discipline and encourage companies to pursue projects that offer high rates of return. This portfolio’s dividend yield has persistently ranked in the top decile of the Foreign Large Growth Morningstar Category over its short three-year history.

This fund uses a strategy that emphasizes growth over dividend yield. However, it screens for expected earnings growth rather than dividend growth directly. This could pose a risk to the strategy as higher expected earnings don’t necessarily translate into actual dividend payments. Managers may use excess earnings to pay down debt, repurchase shares, or purse other investment opportunities. In addition to future earnings growth, this fund also screens its holdings for profitability using return on equity and return on assets. Indeed, this fund’s holdings have been more profitable than those of many of its category peers. Over the past 12 months through May 2017 this fund’s return on equity and return on invested capital was in the top decile of the foreign large growth Morningstar category.

The focus on dividend-paying stocks combined with screens for quality causes the fund’s sector composition to look different from its peers. This fund has substantially higher allocations to stocks from defensive sectors such as consumer staples and healthcare, while underweighting those from sectors that are more cyclical such as technology and energy. The more defensive nature of this fund also causes it to have lower volatility than its peers. Furthermore, many of the stocks held in this portfolio have wide or narrow economic moat ratings, meaning they have robust competitive advantages.

Wide-moat companies such as Unilever, Roche, and British American Tobacco are among this fund’s top holdings. These are major multi-national firms that have global revenue streams, making their listing country less important. Despite the global presence of this fund’s holdings, foreign investments can offer diversification benefits to a portfolio of U.S. stocks. Over the past three years through May 2017 this fund’s correlation with the Russell 1000 Index has been far less-than-perfect, at 0.73.

International investments do bear an additional layer of risk from fluctuations in foreign exchange rates. This fund has exposure to several major currencies including the pound, euro, yen, and Swiss franc. Over the past several years the U.S. dollar has been strengthening relative to these currencies, which has been a headwind for dollar-denominated returns. Unlike many of its peers, this fund hedges its currency risk. This has benefitted returns over the past several years, however, when exchange rates reverse course this hedging mechanism will work against investors.

Portfolio Construction

This fund uses an alternative approach to weighting stocks based on dividends paid, and the selection criteria also accounts for a firm’s expected earnings growth and profitability. These additional screens should enable the fund to have better risk-adjusted performance than the category, and warrant a Positive Process Pillar rating.

Companies eligible for index inclusion must have shares listed on major stock exchanges in developed foreign markets. Stocks are further pared down to those with a market capitalization of $1 billion or more, and have paid at least $5 million in gross cash dividends over the prior year. Additional liquidity requirements include an average daily dollar volume of at least $100,000 and 250,000 shares transacted each month over the prior 6 months preceding the screening date.

Stocks are then ranked using a weighted combination of three factors: 50% based on long-term estimated earnings growth, 25% on the trailing three-year average ROE, and 25% on the trailing three-year average ROA. The top 300 companies by this combined ranking are available for inclusion. Stocks are weighted based on cash dividends paid relative to the aggregate value of dividends paid by stocks in the portfolio. The managers use currency forward contracts or futures contracts to hedge currency risk, and the index is reconstituted annually in June. The weights of individual stocks are capped at 5%, while countries and sectors are capped at 20% during the annual reconstitution.

Fees

This fund charges an expense ratio of 0.58%. While this appears high, it is well below the category average of 1.15%, and lands in the top decile of the Foreign Large Growth Morningstar category–warranting a Positive Price Pillar Rating. Currency forward contracts are used to hedge the currency risk in this portfolio. The sale of such contracts can trigger capital gain distributions, which this fund made in both 2014 and 2015.

Alternatives

Vanguard International Dividend Appreciation VIGI directly focuses on dividend growth rather than earnings growth or yield. It tracks the NASDAQ International Dividend Achievers Select Index, and holds foreign stocks that have increased their dividend payments in each of the past 7 years. Holdings are weighted by market capitalization, which promotes low turnover and transaction costs. VIGI also falls into the foreign large growth category, but return on equity and return on invested capital are lower than IHDG. It charges an expense ratio of 0.25%.

Vanguard International High Dividend Yield VYMI (0.32% expense ratio) tracks the FTSE All-World ex-US High Dividend Yield Index. This strategy sorts foreign dividend-paying stocks by forecasted yield, holds those representing the higher-yielding half, and weights them by float-adjusted market capitalization. This fund does not perform any additional screening for quality or profitability, and may hold stocks with deteriorating fundamentals. The emphasis on stocks with high dividend yields introduces a value tilt to this portfolio, placing VYMI in the foreign large value category.

Other foreign stock funds that hedge their currency risk include iShares MSCI Currency Hedged EAFE ETF HEFA (0.36% net expense ratio) and Deutsche Currency Hedged EAFE Equity ETF DBEF (0.35% expense ratio). Both of these funds track the MSCI EAFE Index and hedge their currency risk with forward contracts. Stocks are weighted by market capitalization, and both of these funds carry a Morningstar Analyst Rating of Bronze.