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How Much Should You Hedge Currencies Today?

By Jeremy Schwartz Currency-hedged exchange-traded funds (ETFs) have been THE story in ETFs over the last three years as one of the leading categories for ETF flows. This has caused some critics to say the movement into currency-hedged ETFs is overdone. First and foremost, we think this assessment underestimates the investment thesis for strategic currency-hedged allocations . More on that below. Second, even based purely on flows, these would-be contrarians are missing the bigger picture. The flows toward currency-hedged ETFs have occurred in two of the smaller pieces of the asset allocation pie-Europe and Japan. When we look at Morningstar categorization for non-U.S. equities, Europe had approximately $88 billion in assets under management (AUM) as of November 2015, Japan had approximately $48 billion of AUM and the foreign large-cap category was approximately $1.3 trillion. 1 While we think Europe and Japan can become bigger categories over time as investors view them more favorably, broad international allocations are more common. In the dedicated European and Japanese category of investments, the adoption of currency hedging has been staggering. Currency-hedged ETFs, which were nonexistent six years ago, now represent as much as one-third of total European-focused AUM in the U.S. and 40% of total Japanese AUM-when including both mutual funds and ETFs. 2 Yet in the broad international category, the trend toward hedging, in our view, hasn’t even started, with only 2% to 3% of the total $1.3 trillion in the category being strategically hedged. WisdomTree believes currency offers uncompensated risk and that most of the $1.3 trillion in assets is taking on more risk than necessary to deliver the returns of international equities. Myths about Hedging Many active managers propagate a generalization and myth that it is expensive to hedge currencies. We see interest rate differentials as the most important cost to hedge. For certain markets, such as Brazil, it could be expensive to hedge because short-term interest rates in Brazil are approximately 14% 3 , and this creates a high hurdle for how much currency has to decline to break even from the hedge. Being Paid More to Hedge But in general, over the last 30 years, an investor was paid on average about 40 basis points (bps) per year to hedge developed world currency exposures 4 . In Japan over the last 30 years, an investor was paid on average almost 2.5% per year to hedge currency exposures simply from the interest rate differentials in the forward contracts. 5 With the U.S. Federal Reserve now raising its Federal Funds Rate, and other central banks continuing to pursue stimulative policy, an investor is now being paid more to hedge foreign currencies in the short run, making hedging even more attractive from an interest rate perspective in 2016 and 2017 than it was in 2015, 2014 or 2013, when currency hedging first took off. This is a reason hedging is becoming more attractive . Is It Too Late to Hedge the Euro and Yen? We argue that currency hedging should serve as the baseline and that investors should add currency risk whenever they view it as less attractive to hedge (or more desirable to have the currency exposure). Investors can switch from hedged to unhedged exposures or blend such strategies together-but now there is a new solution through our dynamically hedged family. This index family solves the challenge of trying to time when currency hedging should be in place. WisdomTree Investments partnered with Record Currency Management to build an index family that incorporates Record’s hedging signals into a dynamically hedged index. 6 Record has been evaluating currency risk and return trade-offs for more than 30 years, and research showed the most important hedging signals for developed world currencies are threefold: The Interest Rate: If the implied interest rate in the United States is higher than that in the targeted currency, it is more attractive to hedge. This signal helps manage the cost to hedge when it is more expensive to do so (like in Australia today). Momentum: Simply put, a downward trend in the targeted currency would signal to put on the hedge, whereas an upward or appreciating trend would signal to take it off. Value: When the targeted currency is overvalued compared to “fair value,” as determined by purchasing power parity (PPP), it is attractive to hedge, and when deeply undervalued, it is less attractive to hedge. Importantly, this is a long-run signal, and a wide band is used in applying this signal. Monitoring the Hedge Ratios by Currency & by Signal Click to enlarge For definitions of terms in the chart, visit our glossary . The currency-hedge signals are determined on an individual currency basis, but in aggregate, for the developed world currency exposures in the WisdomTree Dynamic Currency Hedged International Equity Index , the models suggest hedging 71.05%, and for the WisdomTree Dynamic Currency Hedged International SmallCap Equity Index , they suggest hedging 64.57%. These models are by nature dynamic, and when it is more/less favorable to hedge, some of these hedge ratios will come up/down. While many investors think they missed the opportunity to switch to currency-hedged strategies, we reiterate that we believe the most important drivers of long-term currency movements suggest hedging a majority of your currency exposures today. Sources Morningstar Direct. Europe refers to the universe of U.S.- listed mutual funds and ETFs within the Europe Stock peer group. Japan refers to the universe of U.S.- listed mutual funds and ETFs within the Japan Stock peer group. Broad international refers to the universe of U.S.- listed mutual funds and ETFs within the Foreign Large Value, Foreign Large Blend and Foreign Large Growth peer groups. Data is as of 11/30/2015. Morningstar Direct. Same universes and as of date as the prior footnote. Bloomberg, with data as of 12/31/15. Developed world currency exposures refer to those defined by the MSCI EAFE Index universe from 12/31/1988 to 9/30/2015. Source for paragraph: Record Currency Management, with data from 12/31/1988 to 9/30/2015. No WisdomTree Fund is sponsored, endorsed, sold or promoted by Record Currency Management (“Record”). Record has licensed certain rights to WisdomTree Investments, Inc., as the index provider to the applicable WisdomTree Funds, and Record is providing no investment advice to any WisdomTree Fund or its advisors. Record makes no representation or warranty, expressed or implied, to the owners of any WisdomTree Fund regarding any associated risks or the advisability of investing in any WisdomTree Fund. Important Risks Related to this Article Hedging can help returns when a foreign currency depreciates against the U.S. dollar, but it can hurt when the foreign currency appreciates against the U.S. dollar. Investments focused in Japan or Europe increase the impact of events and developments associated with the regions, which can adversely affect performance. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”

New Year 2016: Looking Back, Moving Forward

The Facts: There were lots of ups and downs in the markets in 2015. Unfortunately, by the time December came to close, there were a few more downs than ups. Although the S&P 500 actually posted a slight gain, it was the index’s softest performance in seven years. We’ll show you what it all means. The Impact: U.S. large caps finished the year up 1.38% (including dividends), while small caps retreated. International stocks fell, with emerging markets dropping almost 15%. Fixed-income markets were relatively flat, though moves by the U.S. Fed triggered unusual volatility. What It Means for Investors: Where some see weakness, there may be opportunity. With a well-diversified portfolio, a simple rebalancing strategy may help investors capture opportunities almost automatically. Read on for what this might mean for each of the major asset classes. A Closer Look As Shakespeare said, “All the world’s a stage,” and a dramatic year for both domestic and international markets may have once again proven him right. It was central banks that took center stage in 2015: The U.S. Federal Reserve (the Fed) made a small but significant step toward tighter interest rates, while looser monetary policy ruled the day in Europe, Japan, China, and elsewhere. The markets were unusually volatile, too, buffeted by several international flashpoints, including financial instability in Greece, a slowdown in China, and terrorist attacks in Paris that grabbed the world’s attention. The end result? Most markets came under pressure in 2015. U.S. stocks ended the year mixed, international markets sagged (especially those in emerging economies), and U.S. bonds ticked slightly higher. Before we take a closer look, let’s quickly review the economic highlights for December. Fed raises rates-finally: The odds makers finally got some rest. On Wednesday, December 16th, the Federal Open Market Committee voted to raise its benchmark interest rate, the federal funds rate, by 0.25%. This was the first interest rate increase in nearly a decade, and the first time in seven years the rate has exceeded the zero to 0.25% range. Projections by Fed governors also suggested that the Fed may increase rates by another 1% through the end of 2016. U.S. economy keeps chugging along: The U.S. showed slow but steady growth throughout 2015. The unemployment rate dropped from 5.6% in December 2014 to 5.0% in November, the most recent month for which we have data, and the workforce expanded by 2.6 million employees. While gross domestic product grew by just 2% through the third quarter, the housing market and other indicators pointed to an economy that continues to expand. Domestic Equities There’s a lot to cover this month, so let’s go straight to the numbers. The large-cap-oriented S&P 500 shed 1.58% in December, but finished the year up 1.38%, the smallest total return for the index since 2008. Without dividends, the S&P actually posted a modest annual decline. The tech-heavy Nasdaq Composite performed significantly better for the year, gaining 6.96% (also including dividends). The month and year were much tougher for U.S. small caps. The small-cap-oriented Russell 2000 shed 5.02% in December-and finished 2015 with an annual decline of 4.41%. Among the sectors that make up the U.S. equity markets (based on the S&P 500 sector indexes), consumer staples, utilities, and health care stocks were the biggest gainers in December, while the energy, materials, and consumer discretionary sectors lagged. The top performers for the year were consumer discretionary stocks, perhaps partially due to lower oil prices leaving more money in consumers’ pockets. Health care and consumer staples stocks also outperformed. On the downside, the energy sector was by far the weakest, falling by 21.12%, followed by materials and utilities. It may be helpful to take a quick look at the energy markets, which struggled considerably in 2015. A glut in global oil supplies triggered a decline of 30.05% in the benchmark New York Mercantile Exchange in 2015-for a total loss of 64% over two years. The last time that crude dropped two years in a row was in 1997-1998. During the course of the year, oil plunged from a high of $61 a barrel to a low of $35, and more than 250,000 jobs in the energy sector were lost on a global basis. For the equity styles, both growth and value stocks were lower in December, though growth slightly outperformed. (We track style performance using the Russell 3000 Growth and Value Indexes.) This theme played out through most of 2015, as growth led value by more than nine percentage points for the year. What to Consider for 2016 : In the spirit of New Year’s resolutions, the start of the year can be a great time to consider rebalancing one’s portfolio to its target allocations. Because U.S. small caps performed relatively poorly in 2015, this could mean adding exposure to small caps by redirecting funds from cash or other assets. (Of course, there’s no guarantee you’ll be reallocating assets at an advantageous time-and tax consequences could be triggered if the transactions are made in a taxable account.) As for U.S. sectors, it’s almost impossible to predict how things will play out. It might be tempting, for instance, to call a bottom in energy at these levels, but even more pain could be ahead, as U.S. crude inventories expand, Iran comes online, and Saudi Arabia fulfills its pledge to meet any increases in demand. Among other sectors, consumer stocks could continue to benefit from the spending power generated by oil price weakness, while higher interest rates could lift financials. International Equities Volatility ruled international stocks in 2015-to vastly different results. Developed markets ended the year just fractionally lower, while emerging markets dropped sharply. The MSCI EAFE Index, a widely followed measure of developed market performance, fell 1.35% in December, finishing the year down 0.81%. Among the component regions that make up the index, Japan was the year’s star performer, while stocks in other Pacific countries and the UK fell sharply. Many Pacific economies were weighed down by the ripple effects of slowing growth in China and depressed commodity prices. Emerging markets saw no reprieve in December. The MSCI Emerging Markets Index fell 2.23% for the month, and ended the year with a loss of 14.92%, the worst annual performance of any index we track. (This was also the index’s third consecutive yearly loss.) Latin America was the weakest region in the index, dropping sharply on lower pricing for some of the region’s biggest exports-oil and other natural commodities. What to Consider for 2016 : Given the underperformance of emerging markets over the past three years, many investors might find that their emerging market holdings have grown smaller relative to other asset classes. If this applies in your situation, now might be a good time to consider adding funds to the category to bring it back to desired target allocation. Investors might even want to reconsider the split in your international allocation-specifically, the amount you hold in emerging vs. developed markets. Valuations for emerging markets are now more attractive than they’ve been in quite some time, and emerging economies still offer the world’s highest (albeit declining) growth rates. Fixed Income The U.S. fixed income market had a relatively flat year, as the Fed finally put an end to the question of “when,” and voted to raise its benchmark interest rate. The Barclays U.S. Aggregate Index was down 0.32% in December, to end the year with a gain of just 0.55%. In the U.S. Treasury arena, the yield on the benchmark 10-year note closed the year at 2.27%. This represented a gain of six and 10 basis points for the month and year, respectively. (A basis point is one one-hundredth of a percent.) For the full-year period, while rates increased across most maturities, the shape of the yield curve remained essentially unchanged. Among the various U.S. fixed income sectors, Treasury bills were the strongest performers in December, while high-yield bonds (also known as “junk” bonds) were the weakest. For the full-year period, intermediate-term U.S. Treasuries led the pack, while high-yield bonds, TIPS, and long-term U.S. Treasuries lost the most. For both periods, high-yield bonds were hit by a number of factors, including the category’s overexposure to the energy sector, and new competition for income from bond sectors that are generally considered less risky. What to Consider for 2016 : While more rate increases are expected by the Fed this year, the bond market may have already priced in some of these moves. Short-tem rates may continue to rise, though this could be tempered by surging demand from yield-starved investors. Long-term rates, which are more influenced by inflation and economic growth than by rate policy, could stay at current levels or rise slightly. If this scenario plays out, the expectation would be for longer-term bonds to outperform their shorter-term counterparts. The Bottom Line Like every year before it, 2015 was full of surprises. But what will happen in 2016? Of course, we can’t predict the future, but there’s one thing we know for certain. Because 2016 is an election year (and there’s no incumbent on the ballot), a new American president will be elected. Other themes that may play out in 2016 include: divergent monetary policy across developed economies (some countries loosening, others tightening); the consequences of higher domestic interest rates, whether intended or not; the effect of higher rates on corporations, particularly those that need to seek funding in the volatile high-yield market; and continued conflict in the Middle East. Plus, we’re sure there will be plenty of new surprises, which makes the financial markets so fascinating to watch and participate in. So what can investors do to prepare their portfolio for the changes ahead? As always, our best advice is fairly straightforward: Stay focused on the long term . Stick to a long-term investing plan by maintaining a risk-appropriate, well-diversified portfolio. This may help prepare one’s investments no matter which way the election goes, or whatever the news may bring. Consider rebalancing periodically to maintain target allocations . January can be a great time to review and refine one’s portfolio to stay in line with pre-set target allocations. This may mean selling some holdings that were relatively successful in 2015, and investing in sectors or regions that underperformed, while keeping in mind that there’s no guarantee of future performance. (If making transactions in a taxable account, it also helps to be mindful of any potential tax consequences.) While it may feel uncomfortable selling winners to buy losers, this strategy follows one of the basic tenets of investing for the long term.