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Currency: The Uncompensated Risk?

Michael Rawson, CFA

Mike Rawson: Hi, I'm Mike Rawson with Morningstar. I'm here today at the Morningstar ETF Conference talking about dividend investing with Jeremy Schwartz. Jeremy is the director of research for WisdomTree. Jeremy, thanks for joining me.

Jeremy Schwartz: Thanks for having me.

Mike Rawson: Jeremy, a lot of people are thinking about investing internationally these days. International markets look to be a little bit cheaper than the U.S., but when they're looking at international investments, particularly dividend funds, how should they think about currency risk? 

Jeremy Schwartz: I have a sort of strong view on this topic, and I call currency "uncompensated risk." You know why you're buying the stock, for the set of earnings, cash flows, incentives that you get for buying that stock. But why are you taking on euro or yen risk when you go overseas? There's no model that tells me that the dollar should always go down against the euro and yen. And that's when you're going unhedged, these institutional unhedged funds, you're betting the dollar will always go down against the euro and yen. So I say be neutral, just buy the stocks that you know you're trying to target. And so currency hedge, I think, is a very important strategic long-run case when you go overseas and you buy these foreign stocks.

Mike Rawson: But some people might argue that, "Well, if I'm investing internationally, don't I want some exposure to foreign currency?" Isn't that part of the appeal to invest internationally? 

Jeremy Schwartz: I think that's a complete misconception. People have been talking about that because really just, that's the options they've had 30 years, and for some part of that year is the dollar was going down. But honestly, it's just a bet, and there's no real true diversification you get from owning currency, that's really a bet. And so you have to have directional belief that say, the euro or yen's going up. And actually, when you look at the data, if you actually thought the euro was going up, it actually would suggest you should not be in European stocks because the stocks underperform as the European currency is going up. So, I think strategically, you say, currency's a form of risk, it adds to your risk profile, but not your expected return profile unless you have a very strong view that that currency's going to appreciate, which most people have no idea where it's going to go. So that's why I say, strategically, it makes more sense to be hedged and you add in the currency if you ever do have a view.

Mike Rawson: Sure. Jeremy, when you're looking for a dividend ETF, you've got a lot of options to choose from. There's something like 50 dividend ETFs out there. A lot of them use a rules-based methodology or a screen or some kind of filter where they'll look for certain characteristics of a stock before they'll allow it in, and then maybe they'll buy 100 with the highest yield. Or maybe they'll look for a stock that has increased its dividend for a very long period of time, such as 10 years. Now, WisdomTree's been out there with their dividend products for a very long time. You launched some products in 2006 and I think you came up with a very elegant solution to this challenge of picking high-yielding stocks without picking the junkier value traps. Can you talk a little bit about your approach?

Jeremy Schwartz: Yeah, I'd say we have three categories of dividend indexes, and two of them we launched in 2006 and one was more recently launched, in 2013. But the big category starts with owning all the dividend-payers. So I call it the beta of dividends. So you're getting the true representative sample of all the dividend-payers in the U.S. and the total market's around 1,500 dividend-payers in the US. We weight those companies by their aggregate cash value of dividends. So, Apple pays $12 billion in dividends, that's $400 billion total [dividends paid in the U.S.]. So Apple's weight is at 12 billion over 400, about 3% weight. You anchor back to that every year on an annual basis, so it's not a yield-weighted concept, a per-share-weighted concept, like what you're talking about, where you have mid-/ small-cap companies that bias the portfolio, and is really, that yield-oriented sensitivity. Here you're giving bigger weights to companies growing their dividends.

Within that total market universe, we had to create large, mid-, and small caps, but we also have two sub-families, one is the high-dividend strategy, that is more the yield selection, that is just driven by the highest dividend yields. That's where we get value stock selection. And we have this new family called quality dividend growth, to try and identify companies that can grow their dividends faster over time, with a forward-looking methodology using return on equity, return on assets, and earnings growth expectations as sort of the forward-looking predictors of where dividends can go.

Mike Rawson: Sure, now you touched on this topic in your answer there about rebalancing the total dividend approach. It's forced to rebalance stocks over a certain period of time. But what I like about it is that the stocks whose prices have appreciated faster than their dividends will rebalance in a different way than the stocks whose maybe dividend has gone up but maybe their stock hasn't gone up. Can you talk about that rebalance effect? 

Jeremy Schwartz: Yeah, the key when you're anchoring back to that Apple's at $12 billion over $400 billion, that 3% rate for Apple. If Apple stock were to double, it would go from 3% weight to 6%, if its dividends don't double, we're going to sell Apple back down to the 3% weight. If it started at 3%, its stock fell in half to 1.5, but its dividends were constant, you would add back to the 3%. So you're always evaluating the price performance versus the dividend performance, and sort of making that discipline to sell when stocks are getting more expensive on a dividend basis and buy stocks when they're getting cheaper on a dividend basis.

Mike Rawson: Jeremy, thanks for those insights.

Jeremy Schwartz: Thanks so much.

Mike Rawson: For Morningstar, I'm Mike Rawson.