Structure Matters: Hedging South Korea

August 04, 2015

This column is part of a new collection of our “Structure Matters” series of interviews with leading ETF and index industry figures. They are conducted by Dan Weiskopf, a portfolio manager at New York-based Access ETF Solutions LLC. In today’s piece, Weiskopf interviews Jeremy Schwartz, director of research at WisdomTree, about what factors investors should look to when they are addressing the currency question regarding South Korea.

Dan Weiskopf: What factors should investors be monitoring to know whether they want to be hedged on the South Korean won?

Jeremy Schwartz: Certainly the currency volatility is one important factor. You saw this where the Korean won was trading versus the dollar; it bottomed out in 2014 at around 1009. It was getting close to the 1,000 level and it started making the Koreans more uncomfortable.

They started talking about it more in the rhetoric, saying the strengthening won was hurting them. Now they’re at 1,143. You have seen almost an 11 percent depreciation just in the last 12 months. You’re seeing that currency start to weaken.

When I look at what the factors about hedging, the cost to hedge is certainly an important factor. That cost to hedge is based on interest-rate differentials, which are coming down as the Koreans are cutting interest rates.

Today their [similar] Fed fund type rate is at 1.25 percent, down from 1.5 percent after a recent cut. In the context of our potential rise in interest rates, I think the interest-rate differential versus the U.S. will just get wider and more interesting.

As we raise rates and as they lower rates, that cost can converge toward zero, which means investors could possibly get paid for the hedge over the next 12 to 18 months. Now that would be a big deal.

But the Koreans are not just worried about the dollar. They're increasingly focused on the won versus the yen. It used to be essentially 7 won to the yen, and now it's 11. That’s a 50 percent depreciation versus the yen, which makes Japan a lot more competitive. If the yen keeps depreciating, I would expect the Koreans to take more action to weaken their currency.

Weiskopf: You mention in a recent white paper that equities in South Korea are trading at 2009 levels. What factors have led to this discount, and what catalysts should we be looking to that might lead to a narrowing of this discount?

Schwartz: The valuation that we say is at 2009 levels is the price-to-sales ratio, which is at 0.6. There are very few countries trading at that low multiple. Even Russia is selling at a 0.8 price-to-sales ratio. I think the factor that is hurting South Korea is the profitability of its companies, which again is clearly helped by a weaker currency, given that their economy is so export-driven.

We wrote a piece recently that showed a chart that essentially compared the profitability of the consumer discretionary companies in South Korea versus Japan, and the relative profit differential there was dramatic.

When you even look at a price-to-earnings ratio, 10 to 11 times earnings for South Korea—knowing that the broad developed market index is 15 to 16 times earnings and the U.S. is at 17 to 18 times earnings—you see it's relatively on the lower price range of developed or emerging market. But even for the standard price-to-earnings ratio, which includes that lower profitability, you can see Korea is a relatively low-priced country.

With a weaker won, the profitability of the companies exporting would become more profitable, which itself would make the market cheaper and arguably provide more of a reason to narrow the valuation gap.

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