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Is Volatility A Useful Signal For Dynamic Currency Hedging?

By Jeremy Schwartz WisdomTree and Record Currency Management Ltd. 1 partnered to create a family of dynamic currency-hedged Indexes that utilize three factors to determine the dynamic hedge ratio on each individual currency: interest rate differentials, momentum and value. In the field of currency hedging one oft-debated question is whether there are other effective signals and, in particular, whether volatility could also be a useful signal. We have, of course, carefully considered which signals we believe to be most optimal, and although we recognize that volatility in currency markets can show patterns of behavior, we are convinced that it is not an appropriate independent signal to use in a hedging strategy, for the simple reason that volatility is by definition non-directional. Volatility Does Not Dictate Direction What do we mean by non-directional? Simply that rising (or falling) volatility tells us something about the size of observed movements in a currency pair, but nothing about the direction of those movements. Knowing that the standard deviation of exchange rate movements has become wider or narrower could be consistent with either one currency strengthening or the other-or, indeed, neither. In a dynamic currency-hedging strategy, which is naturally long equities, the only trade available is to be currency hedged (e.g., long U.S. dollar and short euro, or yen, or another currency)-or not. Since the purpose of dynamic hedging is to seek greater exposure to hedges that are expected to be profitable, and less exposure to hedges that are expected to be loss-making, it is essential for each signal to have some explanatory power as to which currency in any pair is expected to appreciate, i.e., to be directional. An example may serve to illustrate the point. We have tried to create a signal hedging strategy that is as widely applicable within developed market currencies as possible, without having been ” curve-fitted ” to one particular domestic currency or set of foreign currencies. Volatility seems to defy this. If, for example, one investor was looking for a strategy that worked well for hedging euro exposure into dollars, and another wanted to hedge dollar exposure into euros, then rising volatility in the euro/dollar exchange rate might tell both of them to hedge more. Since the exchange rate will only go one way, only one of these hedges will be profitable, while the other will be loss-making-so the signal will have worked for only one of the investors. Interest Rates, Value and Momentum Are Directional Hedging Signals By contrast, higher U.S. interest rates, or the momentum of the U.S. dollar, or an undervalued dollar, will all signal to U.S. investors to hedge their euro exposure, while also being a signal to euro-based investors to not hedge their U.S. dollars. These three signals are thus consistent by virtue of being directional. Looking for Volatility Reduction? Adopt Full Passive Hedging Finally, there’s the question of whether an investor wouldn’t always want to hedge more in a more volatile environment, simply because currency movements are at risk of being bigger. To this we would respond that bigger movements can come in both positive and negative directions, so once again the directionality of the signal is vital. If an investor is concerned about currency volatility, a full currency-hedged strategy may be most appropriate, as the long-term results showing currency exposure in a broad international framework has historically increased the volatility of international investments. 2 This is why WisdomTree has long suggested that fully currency-hedged strategies could serve better as core, strategic long-run allocations. Dynamic Hedging Can Help Returns The goal of the dynamic hedged Indexes WisdomTree and Record created were to tactically add value and return potential above fully hedged and fully unhedged offerings by incorporating the dynamic signals. Our signals were designed to be directional, so while they do lower volatility compared to unhedged benchmarks, they are likely to see a small volatility pickup over a fully hedged strategy. But our research leads us to believe that higher returns could compensate investors for this small pickup in volatility. Sources 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 Funds regarding any associated risks or the advisability of investing in any WisdomTree Fund. WisdomTree, Bloomberg, as of 12/31/2015. 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. 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.”

Monitoring Your Portfolio’s Dollar Sensitivity

By Tripp Zimmerman At WisdomTree, we continue to believe one of the most important themes impacting the global markets has been the strengthening U.S. dollar-and this is a trend we expect to continue for some time. As a result of the recent dollar strength, many U.S. multinationals with global revenue streams have reported currency headwinds as part of their earnings statements over the past year. This has hurt their performance compared to European and Japanese exporters, who have benefited from the weakening of the yen and the euro, respectively, against the U.S. dollar. This relative performance advantage is no surprise to us, because our research shows that these foreign markets actually performed better when their home currencies depreciated than when they appreciated. 1 Given this historical relationship and relative valuations, we continue to advocate for Japanese and eurozone exporters. But how should investors position their U.S. allocations? U.S. Corporations Continue to Warn about Dollar Strength “Sales by U.S. companies were $26.4 billion in the fiscal nine months of 2015, which represented an increase of 0.8% as compared to the prior year,” Johnson & Johnson (NYSE: JNJ ) reported. “Sales by international companies were $25.9 billion, a decline of 13.5%, including operational growth of 1.1%, offset by a negative currency impact of 14.6% as compared to the fiscal nine months sales of 2014.” 2 The Coca-Cola Company (NYSE: KO ) reported that over the most recent three months “fluctuations in foreign currency exchange rates decreased our consolidated net operating revenues by 8 percent. This unfavorable impact was primarily due to a stronger U.S. dollar compared to certain foreign currencies, including the South African rand, euro, U.K. pound sterling, Brazilian real, Mexican peso, Australian dollar and Japanese yen, which had an unfavorable impact on our Eurasia and Africa, Europe, Latin America, Asia Pacific and Bottling Investments operating segments.” 3 Determining Your Dollar Sensitivity WisdomTree believes currency sensitivity is an important factor that will continue to impact returns going forward, so to monitor the performance of this new factor, WisdomTree has created two new rules-based Indexes: The WisdomTree Strong Dollar U.S. Equity Index (WTUSSD) – This Index selects companies that generate more than 80% of their revenue from within the U.S. and then tilts its weight toward stocks whose returns have a higher correlation to the returns of the U.S. dollar. The WisdomTree Weak Dollar U.S. Equity Index (WTUSWD) – This Index selects companies that generate more than 40% of their revenue from outside the U.S. and then tilts its weight toward stocks whose returns have a lower correlation to the returns of the U.S. dollar. Since the inception of these Indexes, the U.S. dollar has strengthened 2.95% against a diversified basket of developed and emerging market currencies, leading to a performance advantage of 1.72% for WTUSSD compared to WTUSWD. 4 To try to understand what is behind this performance difference, we chart the median earnings and sales growth for the most recent quarter compared to the same reporting quarter one year ago, for both Indexes and the median for the entire universe. Year-over-Year Median Earnings and Sales Growth (click to enlarge) Strong Dollar Companies Displayed Higher Growth- The median earnings and sales growth for constituents of WTUSSD was more than 6% and 7% higher, respectively, compared to constituents of WTUSWD. We believe constituents of WTUSSD, or companies that generate more than 80% of their revenue domestically, tend to be less impacted by a strong-dollar environment-they aren’t focused on selling their goods and services abroad, and their import costs decrease with the rising purchasing power of the dollar. How Long Can This Persist? We have recently published a research paper, What a Rising U.S. Dollar Means for U.S. Equities White Paper , in which we illustrated the declining competitiveness of U.S. exports by graphing a ratio of exports of the U.S. economy over imports. As the U.S. dollar strengthened, the ratio of exports over imports weakened. Historically, we found that the impact can have a lag of around 36 months, so if history is any guide, we may not have seen the worst impact on exporters yet. At WisdomTree, our base case is still for a strengthening U.S. dollar, which may provide a continued headwind to U.S. multinationals with global revenue, but, depending on investors’ views, they can use the above Indexes to track the performance of either basket. Sources WisdomTree, Bloomberg. Johnson & Johnson quarterly earnings report, 10/30/15. Johnson & Johnson had a 1.21% weight in the WisdomTree Weak Dollar U.S. Equity Index as of 11/13/15. The Coca-Cola Company quarterly earnings report, 10/28/15. The Coca-Cola Company had a 0.71% weight in the WisdomTree Weak Dollar U.S. Equity Index as of 11/13/15. WisdomTree, Bloomberg, 5/29/15-11/13/15. U.S. dollar performance against a diversified basket of developed and emerging currencies is represented by the Bloomberg Dollar Total Return Index. Important Risks Related to this Article Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Tripp Zimmerman, Research Analyst Tripp Zimmerman began at WisdomTree as a Research Analyst in February 2013. He is involved in creating and communicating WisdomTree’s thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Prior to joining WisdomTree, Tripp worked for TD Ameritrade as a fixed income specialist. Tripp also worked for Wells Fargo Advisors, TIAA-CREF and Evergreen Investments in various investment related roles. Tripp graduated from The University of North Carolina at Chapel Hill with a dual degree in Economics and Philosophy. Tripp is a holder of the Chartered Financial Analyst designation.

The European Local Recovery: Introducing A New Index

By Jeremy Schwartz Earlier, we discussed how positive trends in the European economy showing domestic growth are leading the eurozone , while global trade has been one of the weak points. 1 We also discussed how our favorite leading indicators of the economy-both M1 growth and the European Commission’s Economic Sentiment Indicator-were showing positive signs that bode well for future trends in the local economy. 2 What could be a good way to position toward this local economic recovery? Creating an Index to Respond Strongly as Economic Conditions Improve At WisdomTree, we build innovative equity Indexes that offer the opportunity to express certain characteristics or have greater potential to respond to different economic trends. If an economic recovery in Europe is truly taking hold, we wanted to create an Index that best reflects these local economic conditions. WisdomTree thus created the WisdomTree Europe Local Recovery Index to reflect attributes of an improving domestic economy that is less reliant on the global export markets. Especially over the past five years, certain more defensive sectors of the MSCI EMU Index have exhibited lower correlation to changes in the economy and the leading indicator of activity, the European Commission’s Economic Sentiment Indicator. These defensive sectors thus may not offer the most representative exposures to improving economic conditions within the eurozone. Over the past five years, those same defensive sectors have exhibited lower betas when measured against the returns of the MSCI EMU Index. In times of turmoil or uncertainty, this could be a potentially positive attribute, but if an investor truly believes in the prospects for a eurozone economic recovery, these lower-beta defensive sectors are likely to be least responsive to a more positive growth environment. Defensive Sectors Less Correlated to Changes in Economic Activity and Sentiment (click to enlarge) Positioning in Cyclicals: No Defensives In positioning for local economy recovery, these data points lead us toward a preference for cyclical sectors over defensive sectors. Within the WisdomTree Europe Local Recovery Index, the Consumer Staples, Health Care, Telecommunication Services and Utilities sectors are not eligible for inclusion. Two important factors are driving allocations in the WisdomTree Europe Local Recovery Index: Stock Selection: In addition to the aforementioned sector screens, there is also a geographic revenue requirement to ensure a domestic European focus: constituents must derive more than 50% of their revenue from inside Europe, giving focus to what is happening within Europe and less sensitivity to the global growth outlook. Weighting: We also employ a weighting methodology to maximize sensitivity to improving economic conditions. This process tilts the weight toward stocks whose returns have been most correlated to changes in economic conditions, defined by the European Commission’s Economic Sentiment Indicator discussed above. This unique weighting methodology ranks stocks by their correlation to the Economic Sentiment Indicator and, using a smoothed weighting process, tilts weight from the traditional benchmark market capitalization weights toward stocks that are more responsive to changes in economic sentiment and activity. Formally, the weights are set by two factors: 25% according to their market capitalization percentages, and 75% according to how correlated each stock is to economic activity over the last five years (based on each stock’s returns and its relationship to the European Commission’s Economic Sentiment Indicator). Bottom Line 3 : Local Focus: WisdomTree Europe Local Recovery Index has nearly 70% of its weighted average revenue coming from within Europe. Opposite of WisdomTree Europe Hedged Equity Index: This is a distinctly complementary approach to that employed by the WisdomTree Europe Hedged Equity Index, which requires constituents to derive more than 50% of their revenue from outside Europe. The weighted average revenue exposure from Europe in that Index is only 30%. Unhedged Local Exposure Complements Hedged Exporters: There has been a huge amount of interest in currency-hedged eurozone exporters in 2015. The unhedged local recovery basket provides a nice complement both from its unhedged nature and the distinctly different profile of stocks represented in the local recovery Index. Based on the macroeconomic trends discussed in our blog post ” A Recovering Eurozone Economy: Where Should You Position? ,” this local recovery index should also be a focal point for traditional unhedged replacements, as the local economy is showing relative strength within the European economy. Sources Bloomberg, Eurostat and WisdomTree, with data as of 6/30/15. Bloomberg, European Commission, European Central Bank and WisdomTree, with data as of 9/30/15. Bloomberg, FactSet, with data as of 9/30/15. Important Risks Related to this Article Investments focused in Europe increase the impact of events and developments associated with the region, 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.”