How Dynamic Currency Hedged ETFs Work

February 03, 2017

Luciano Siracusano is WisdomTree’s chief investment strategist. He is the co-creator, with CEO Jonathan Steinberg, of WisdomTree’s patented indexing methodology. Siracusano led WisdomTree’s sales organization from October 2008 until June 2015, while also serving as the firm’s chief investment strategist. ETF.com caught up with him at Inside ETFs to discuss the dynamic hedged ETFs that were launched last year.

ETF.com: Last year at this time, WisdomTree had just launched its dynamic hedged products. Would you talk a little bit about that?

Luciano Siracusano: The one that we put the most focus on is the one that's done the best. That's the WisdomTree Dynamic Currency Hedged International Equity Fund (DDWM), which is the broadest one, and that goes up against the EAFE [Europe, Australasia and Far East] products [such as the iShares MSCI EAFE ETF (EFA)], but dynamically hedges out the currency every month. That's up to $340 million in assets.

So it's definitely had a good, quick uptake. The nice thing about it is that the performance in 2016 was really terrific. It beat both EFA and 100% hedged EAFE [such as the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF)]. We were 70-80% hedged most of the year.

Chart courtesy of StockCharts.com

 

ETF.com: And what was the key to that; the flexibility in the hedge?

Siracusano: It was the combination of getting the right calls on the major currencies. I think we were nearly totally hedged out on sterling before it collapsed. And we were hedged out on the euro for most of the year—83% or so.

ETF.com: How is that determined?

Siracusano: It's determined each month based on three signals. One of them is the interest-rate differential between the foreign currency and the U.S. The second one is momentum. It's really a technical signal based on short-term movements in the price momentum. And the third one is a longer-term signal based on valuation. It's a measure of the purchasing power parity between the foreign currency and the U.S.

Those three signals together, over time, in our research, all added value as a signal. And when you combine them together, you have the potential, we think, to squeeze out about a percentage point a year of return from the lion's share of the dollar-up move or protecting when the dollar's declining.

 

The goal is not to get every currency bet right 100% of the time. When you have these four- to eight-year moves in the dollar, the goal is to capture the lion's share of the movement in the sense that if you're predominantly hedged, you don't get that 4-5% a year head wind on the struggling dollar, which is one of the things that impacted international equity returns these last five years.

It's no coincidence that emerging markets is basically flat over five years, and EAFE, I think, returned more than a percent for 10 years. A good portion of it is the head wind caused by that rising dollar.

The goal is to get hedged when the dollar is strengthening, and then to remove the predominance of the hedges as the dollar's declining in value. Those movements tend to last six, seven years and they tend to net out over time. But if you can capture the lion's share each way, we think there's a way to add value.

ETF.com: And there’s a small-cap version, too?

Siracusano: There's the WisdomTree Dynamic Currency Hedged International SmallCap Equity Fund (DDLS), where we hedge out the currency dynamically in the international small-caps. We're also doing it now in Japan [the WisdomTree Dynamic Currency Hedged Japan Equity Fund (DDJP)] and in Europe [the WisdomTree Dynamic Currency Hedged Europe Equity Fund (DDEZ)].

ETF.com: Is there the potential those would cannibalize your straight-hedged products?

Siracusano: I don't think so; it's just completing the product suite and it's giving people three ways to get the exposure. We're giving a way to own that exposure hedged, or dynamically hedged or unhedged.

Historically, investors would outsource it to an active manager, but the problem is that most active managers really don't manage currency risk very well. If you look at EAFE hedged over the last five years, it beats about 99% of the active managers in the international space. What that means is that the active managers have not been managing currency risk.

If you want to outsource that decision, we’ve created a dynamic hedged strategy that does that. It makes the decision for you at the end of every month about what currencies you should be hedging. And it's not as if we're hedging them 100%; there are gradations. Some are hedged 33%, some are hedged 50%, some are hedged 83%.

ETF.com: Let’s talk about Japan. The economy there seems to be in a quagmire.

Siracusano: It takes a long time to change direction of that aircraft carrier, if you will. We have a team in Japan on the ground, and they say there’s been a pickup in sentiment the last quarter. We're starting to see a bottoming to the disinflationary trend, which is really the big thing. If they can get inflation to start picking up, that's very productive.

 

ETF.com: And we're seeing that in Europe a bit. We're seeing it in the U.S.

Siracusano: You're seeing it in Europe. You're seeing the disinflationary trend stopping in Japan, and now you're starting to see the corporations put that cash on their balance sheet back to work. They're buying back stock. They're raising their dividends. If there's any kind of infrastructure plan in America, Japanese exporters will probably benefit from that and sell into it.

But also in Japan, you’re seeing part-time workers finally getting full-time employment. And that's a big thing, because it helps the younger Japanese get out of the home that they were living in with their parents, get married and then start to have their own household.

You're starting to see pickup in real estate prices, which is a good signal in Japan; they haven’t had that in a long time. And the Japanese companies are really set up in 2017 to have very, very strong profit growth with where the yen is today; it's about 113 to the dollar. Most of the analysts were making their forecasts when the yen was about 103. For the most part, they really haven't adjusted those numbers upward yet to reflect the weaker yen.

ETF.com: How does Trump pulling out of the trade Trans-Pacific Partnership trade deal affect Japan?

Siracusano: Well, Japan wanted it. It was important for Japan. It's interesting, because South Korea was not part of that trade PAC. Japan wants to reserve the right to negotiate directly with Korea on trade because it's so central. But if they can negotiate with a dozen countries at the same time, they may end up benefiting, because not all the countries are watching their relationship vis-à-vis Japan. The thinking was, net/net, Japan would have benefited more than the U.S. would have benefited by that trade pact.

This is not to say there won't be a renewed trade agreement, but it'll be bilateral. The Japanese will have to negotiate directly with Trump, just as they're prepared to negotiate directly with the Koreans. That's the direction Trump wants to go. He thinks he can get a better deal by just negotiating directly.

ETF.com: And that would be the case with Europe, too, in some ways, right? So you're seeing more of these collective trade agreements.

Siracusano: Yes. I think you'll see that with the U.K. now. I think the U.K. will want to do a lot of bilateral agreements directly in the English-speaking world, and then branch out from that. It remains to be seen what happens to global trade once you get more of these bilateral agreements.

The key thing for Trump will be, can he pass tax cuts quickly? Or will tax cuts be held hostage by tax reform? And then, what's going to take longer to pass? Because if the tax reform happens, there's no guarantee it'll be retroactive through 2017. It may not start till 2018. And if so, that would have an impact on the market, because it's starting to discount the impact of a lower corporate tax rate, though not completely.

We're very constructive on 2017. We think it's going to be a good year for equities. We think it's going to be a good year for the U.S. economy. We like U.S. midcaps and U.S. small-caps. And we continue to like Japan in particular, if you're hedging a currency.

 

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