New York (Reuters) – Algorithms are proving to be poor at timing currency markets, if a group of new exchange-traded funds is any indication.
In January, ETF-industry leaders BlackRock’s iShares unit and WisdomTree Investments both launched slates of international stock funds that are inconsistently hedged against currency moves, based on when and how their algorithms tell them to hedge.
So far this year, of the seven funds in both groups, only one is performing better than comparable funds that are unhedged. Three of the seven also lagged comparable funds that were fully hedged against currency moves.
The funds—iShares' "Adaptive Currency Hedged" ETFs and WisdomTree's "Dynamic Currency Hedged funds”—attempt to protect U.S. investors from losing money on winning international stocks when they collect their foreign profits in pricier U.S. dollars.
Algos Predict When To Hedge
Using algorithms to predict the currency's direction, the index funds choose when to "hedge," buying contracts that fix their exchange rate and protecting investors' winnings if a foreign currency falls.
But their predictive models—reset only once a month—may have been caught short by Britain's June 23 "Brexit" vote to leave the European Union, which was followed by an immediate sharp decline in the pound and rally in the yen.
The funds need more time to demonstrate their abilities, said iShares Product Consultant Dorothy Lariviere. In prelaunch testing, the Adaptive indexes beat a portfolio split evenly between a fully hedged and unhedged strategy, she says.
WisdomTree Research Director Jeremy Schwartz said he expects Dynamic funds—which he calls the future of international-stock investing—to beat their counterparts over the long term.
Inside The Black Box
Each fund company's algorithm is different and weighs multiple factors, but both hedge more when a currency they have exposure to has recently been depreciating, on the premise that the currency would continue on that path.
But betting on momentum could backfire when currency directions change. In June, for example, the dollar fell 6.7% against the yen while the iShares Adaptive Currency Hedged MSCI Japan ETF (DEWJ | F-37) was 75% hedged in the opposite direction.
Adjusting hedges more frequently could raise transaction costs and "pick up a lot of false signals" from temporary currency fluctuations, said James Wood-Collins, chief executive of Record Currency Management Ltd., which helped WisdomTree create the Dynamic indexes.