WisdomTree Research
REDUCED YEN EXPOSURE
[ December 2016 ]
Why We Reduced Yen Exposure in
Dynamic Foreign Exchange Equity Indexes
BY JEREMY SCHWARTZ, CFA®, DIRECTOR OF RESEARCH
One of the big moves in global markets this November was the rise of the U.S. dollar. Some of the sharpest gains in the U.S. dollar
came against the Japanese yen, which was trading at close to 103 yen to the dollar in early November, but by the end of November,
the dollar was purchasing almost 11% more yen, at almost 114.5.1
Like many of the moves in the markets after Trump was elected, this caught many by surprise.
During the last three to four years, investors embraced currency-hedged2 equity strategies to neutralize the impact of exchange
rates, especially during periods of U.S. dollar strength and foreign currency weakness. But investor flows through November 2016
reduced international equity exposures, particularly positions obtained with currency hedges in place.
WisdomTree questions the strategic rationale for always taking foreign currency exposure unhedged3 and has been telling investors
about the additional volatility that comes with layering in a bet on foreign currencies on top of broad-based international equity
indexes and funds.
In our opinion, the true neutral starting point for developed world exposures broadly should be to take risk that investors are
compensated to take—which we believe is equity market risk, at an equity market risk premium4, but not currency risk—and one
should add in currency exposure if one ever has a view on foreign currencies appreciating.
Are there currency factors that suggest when it’s a better time to hedge or to have currency exposure unhedged?
WHAT ARE THE SIGNALS THAT CURRENCIES MIGHT APPRECIATE?
The Japanese yen illustrates which factors can drive currency movements and how investors can look to dynamic hedging5
index-based strategies to strategically allocate to international stocks.
Sources: WisdomTree, Bloomberg. Early November refers to 11/3/16, and end of November refers to 11/30/16.
Currency hedging: Strategies designed to mitigate the impact of currency performance on investment returns.
3
Unhedged: Strategy that includes the performance of both the underlying asset as well as the currency in which it is denominated. The performance of the currency can either
help or hurt the total return experienced.
4
Risk premium: Equity investments are not risk free, but it is thought that investors buy stocks because the returns they expect are high enough to allow them to take the risk.
5
Dynamic hedge: Strategy in which a currency hedge can be varied (as opposed to targeting a constant level) and change over the course of time.
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WisdomTree Research REDUCED YEN EXPOSURE [ December 2016 ]
Our research on factors that drive currency movements has focused on three primary signals:
interest rate differentials,6 momentum7 and value.8 You may have heard the phrase “value and momentum everywhere.” In our
view, those two factors help explain currency moves.
In collaboration with Record Currency Management, WisdomTree developed a series of Indexes, including the WisdomTree
Dynamic Currency Hedged International Equity Index, which employs signals that combine interest rate differentials (or carry9)
with value and momentum, because interest rates also contribute meaningfully to currency returns. This joins the WisdomTree
International Equity Index and the WisdomTree International Hedged Equity Index, which track the same basket of stocks while
offering different approaches to international currency risk.
At the very least, by not hedging currencies that are expensive to hedge because of a high carry cost (as is now the case in
Australia), you can potentially turn the cost of hedging from paying carry and into your favor by hedging only when you are paid
carry to do so, through positive interest rate differentials (as you are today in the euro, yen and Swiss franc). Whether or not the
spot exchange rate10 moves in the direction of the currency that has the carry advantage, this process is designed to have interest
rates contribute to returns through rate differentials embedded in forward contracts.11 On average and over time, the interest rate
carry makes up for any losses that might occur in spot exchange rate markets.
The index process was designed to mitigate overfitting of the data to optimize a currency hedging signal for a given currency.
These signals can become more or less important for a given market regime, but each has shown evidence of being important for
driving currencies over time and the cross-section of currencies.
Regimes can last a long time when individual factors are less relevant for a particular currency. For example, in the last 20 to 30
years, there were not many signals that came from Japan/the yen when it came to interest rate differentials or the yen’s valuation.
On Rates: The Bank of Japan has employed a policy of low interest rates for much of the last 30 years, so a hedging signal for the
yen would have suggested remaining hedged over this entire time, as the U.S. had consistently higher interest rates.
On Value: Similarly, on a valuation basis, the yen looked expensive persistently for much of the last three decades, and a dynamic
valuation-based signal would have suggested staying hedged for most of the period. Only once in this last 30 years did its valuation
signal ever enter a neutral territory, and it never became so cheap to warrant unhedging on a pure valuation signal.
Interest rate differentials: The difference between the two-year interest rate swaps of the United Kingdom vs. the United States.
Momentum factor: The average return of stocks with high momentum minus the average return of stocks with low momentum after adjusting for size.
8
Value: Characterized by lower price levels relative to fundamentals, such as earnings or dividends. Prices are lower because investors are less certain of the performance
of these fundamentals in the future.
9
Carry: The amount of return that accrues from investing in fixed income or currency forward contracts.
10
Spot exchange rate: The price to exchange one currency for another for immediate delivery. The spot rates represent the prices buyers pay in one currency to purchase
a second currency.
11
Forward contracts: Agreements to buy or sell a specific currency at a future date at an agreed upon rate.
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WisdomTree Research REDUCED YEN EXPOSURE [ December 2016 ]
Momentum: Momentum was the primary factor that worked especially well for signaling when to hedge the yen. Momentum
moves around more than interest rate differentials or valuation signals, and ultimately could be described as a catchall factor for
any other forces that might pull a currency in one direction or another other than raw carry spreads and valuations. Research shows
that when currencies trend, they tend to continue trending.
FIGURE 1: MOMENTUM FACTOR
JPY Spot Rate
10-day Moving Average
240-day Moving Average
165
USD/JPY Spot Rate
(10 day m.a. crosses 240 day m.a. below to hedge, above to unhedge)
Strong USD
155
145
135
125
115
105
95
85
75
20
06
20
08
20
10
20
12
20
14
20
16
20
08
20
10
20
12
20
14
20
16
20
00
20
00
20
06
19
98
19
98
20
04
19
96
19
96
20
04
19
94
19
94
20
02
19
92
19
92
20
02
19
90
19
88
100%
50%
0%
19
88
Hedge Ratio
19
90
65
Strong JPY
Sources: WisdomTree, Record Currency Management, Reuters, Bloomberg, for the period 12/31/1987–11/30/2016.
Past performance is not indicative of future results.
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WisdomTree Research REDUCED YEN EXPOSURE [ December 2016 ]
Strong USD
180
JPY Spot Rate
Interest Rate Differential
USD/JPY Spot Rate
160
6.0%
140
4.0%
120
2.0%
100
0.0%
80
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
20
14
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
20
14
20
16
19
92
-4.0%
19
92
40
19
90
-2.0%
19
90
60
19
88
Strong JPY
100%
50%
20
16
0%
19
88
Hedge Ratio
8.0%
Interest rate differential implied in 1-month
forward FX rate (USDJPY, % p.a.)
FIGURE 2: INTEREST RATE FACTOR
FIGURE 3: VALUE FACTOR
50
100
50% HR
150
JPY/USD Smoothed Spot Rate
Monthly (USD/JPY) PPP
PPP - 20%
PPP + 20%
200
250
Strong USD
20
00
20
02
20
04
20
06
20
08
20
10
20
00
20
02
20
04
20
06
20
08
20
10
20
16
19
98
19
98
20
16
19
96
19
96
20
14
19
94
19
94
20
14
19
92
19
92
20
12
19
90
19
90
100%
50%
0%
19
88
Hedge Ratio
19
88
300
20
12
USD/JPY Spot Rate
(Shown with +/- 20% of PPP as
part of the value signal)
Strong JPY
Sources: WisdomTree, Record Currency Management, Reuters, Bloomberg, for the period 12/31/1987–11/30/2016. Past performance is not indicative of future
results. Purchasing power parity (PPP): Academic concept stating that exchange rates should adjust so that equivalent goods and services cost the same across
countries, after accounting for exchange-rate differences. HR: Hedge ratio.
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WisdomTree Research REDUCED YEN EXPOSURE [ December 2016 ]
SIGNALS CONTRIBUTING TO THE REDUCED YEN EXPOSURE IN WT’S DYNAMIC FOREIGN EXCHANGE (FX)12 HEDGED
INDEXES IN NOVEMBER
There have not been many changes to the yen’s momentum over the last four to five years. Momentum regimes have changed on
average less than two times a year, and in 2016 there was no change in momentum over the last 12 months.
In November 2015, the yen’s momentum—using a 10-day versus 240-day moving average rule—went from depreciating to
appreciating. Our dynamic hedge ratio13 for the yen was thus reduced in December 2015 from 83.3% to 50%. Compared with being
fully hedged, this dynamic change was useful and captured yen appreciation from 120.31 to 109.2.14
One year later, the hedge ratio increased back to 83.3%, meaning the overall yen exposure was reduced in a broad basedinternational dynamic hedging strategy.
No strategy can perfectly time switches, but this rotation in the yen hedge ratio added value.
EVALUATING REAL-TIME PERFORMANCE
We have 11 months of real-time results for this international family of dynamically hedged exchange-traded funds, and we can
evaluate how they’ve done during a period of perplexing currency moves and volatility.
Below, we show the results for the WisdomTree Dynamic Currency Hedged International Equity Fund (DDWM) compared to a fully
hedged and adaptively hedged15 index from MSCI since the inception of DDWM, along with fully hedged and unhedged versions
of the same WisdomTree strategy. The real-time results show an impressive start for the WisdomTree dynamic FX approach.
Foreign exchange (FX): The exchange of one currency for another, or the conversion of one currency into another currency.
Dynamic hedge ratio: Refers to the percent of currency risk that a strategy is seeking to mitigate at a particular point in time.
14
Appreciation from 12/28/15–11/15/16. Sources: WisdomTree, Bloomberg.
15
Adaptive hedge: Using a rules-based strategy to hedge systematically.
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WisdomTree Research REDUCED YEN EXPOSURE [ December 2016 ]
FIGURE 4: INTERNATIONAL EQUITY CUMULATIVE RETURN [ January 7, 2016 - November 30, 2016 ]
9.2%
9.0%
7.1%
5.0%
4.9%
4.1%
0.0%
11
/3
0/
20
16
8/
31
/2
01
6
7/
31
/2
01
6
6/
30
/2
01
6
5/
31
/2
01
6
4/
30
/2
01
6
3/
31
/2
01
6
2/
29
/2
01
6
1/
7/
20
16
-10.0%
10
/3
1/
20
16
WisdomTree Dynamic Currency Hedged International Equity Fund
WisdomTree International Equity Fund
WisdomTree International Hedged Equity Fund
MSCI EAFE Adaptive Hedge to USD Index
MSCI EAFE 100% Hedged to USD Index
-5.0%
9/
30
/2
01
6
Cumulative Return (%)
10.0%
Sources: WisdomTree, FactSet. Past performance is not indicative of future results. You cannot invest directly in an index. Index performance does not
represent actual fund or portfolio performance. A fund or portfolio may differ significantly from the securities included in the index. Index performance assumes
reinvestment of dividends but does not reflect any management fees, transaction costs or other expenses that would be incurred by a portfolio or fund,
or brokerage commissions on transactions in fund shares. Such fees, expenses and commissions could reduce returns. WisdomTree, its affiliates and their
independent providers are not liable for any informational errors, incompleteness or delays or for any actions taken in reliance on information contained herein.
Additional index information is available at www.wisdomtree.com and www.msci.com.
Average Annual Total Returns as of 9/30/2016
Fund Information
Fund/Index
Ticker
WisdomTree Dynamic Currency Hedged
International Equity Fund
DDWM
WisdomTree International Hedged Equity Fund
Fund
Expense
Inception
Ratio
NAV Return
Market Price Return
YTD
1-Year
5-Year
10-Year
Since
Fund
Inception
YTD
1-Year
5-Year
10-Year
Since
Fund
Inception
N/A
N/A
8.69%
N/A
N/A
N/A
N/A
9.80%
1/7/16
0.35%
N/A
N/A
HDWM
7/9/15
0.35%
1.03%
6.61%
N/A
N/A
-1.31%
2.12%
5.53%
N/A
N/A
-1.19%
DWM
6/16/06
0.48%
2.73%
6.96%
7.09%
2.12%
3.04%
3.93%
7.34%
7.41%
2.07%
3.06%
MSCI EAFE Index
1.73%
6.52%
7.39%
1.82%
N/A
1.73%
6.52%
7.39%
1.82%
N/A
MSCI EAFE Local Currency Index
-1.61%
4.62%
11.21%
2.20%
N/A
-1.61%
4.62%
11.21%
2.20%
N/A
WisdomTree International Equity Fund
Sources: WisdomTree, FactSet. The net expense ratio of DDWM reflects a contractual waiver of .05% through October 31, 2017.
You cannot invest directly in an index. Performance is historical and does not guarantee future results. Current performance may be lower or higher
than quoted. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or
less than their original cost. Performance data for the most recent month end is available at www.wisdomtree.com.
WisdomTree shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Total returns are calculated using the daily
4:00 p.m. EST net asset value (NAV). Market price returns reflect the midpoint of the bid/ask spread as of the close of trading on the exchange where Fund shares
are listed. Market price returns do not represent the returns you would receive if you traded shares at other times.
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WisdomTree Research REDUCED YEN EXPOSURE [ December 2016 ]
TREND TOWARD FX HEDGING EQUITIES STILL IN EARLY INNINGS
To reiterate, in WisdomTree’s view, developed world currencies offer higher expected risk levels with no expected return enhancement.
Why should you desire these higher risk levels, unless you are good at timing when you want currency risk to be unhedged?
Adopting a dynamic approach with WisdomTree moves you away from subjective calls and into a disciplined, smart beta16 and factor
approach to currency risk management. We believe our factors (carry, value and momentum) have the potential to outperform both
hedged and unhedged strategies over time by rotating currency hedges with their cycles.
So far in 2016, the signals demonstrated promising added value in a year of large currency moves.
Note that as of November 2016, our signals show an approximate 75% hedged total FX exposure in a broad international strategy.
We believe this is a great read on the current environment and also shows (based on the AUM of unhedged international funds)
that investors following this rules based approach may not want to take on too much unnecessary currency risk when investing
internationally.
Smart beta: A term for rules-based investment strategies that don’t use conventional market cap weightings.
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DDWM is new and has a limited operating history.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To
obtain a prospectus containing this and other important information, please call 866.909.WISE (9473), or visit wisdomtree.
com to view or download a prospectus. Investors should read the prospectus carefully before investing.
This Fund is not sponsored, endorsed, sold or promoted by Record Currency Management Limited (“Record”), and Record makes
no representation or warranty, expressed or implied, to the owners of these Funds regarding any associated risks or the advisability
of investing in the Funds.
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.
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk
of loss from currency fluctuation or political or economic uncertainty. To the extent the Fund invests a significant portion of its
assets in the securities of companies of a single country or region, it is likely to be impacted by the events or conditions affecting
that country or region. The Fund’s exposure to certain sectors may increases its vulnerability to any single economic or regulatory
development related to such sector. The Fund uses various strategies to attempt to minimize the impact of changes in foreign
currency against the U.S. dollar, which may not be successful. The Funds invest in derivatives in seeking to obtain a dynamic
currency-hedge exposure. Derivative investments can be volatile, and these investments may be less liquid than other securities,
and more sensitive to the effects of varied economic conditions. Derivatives used by the Funds may not perform as intended. A
Fund that has exposure to one or more sectors may be more vulnerable to any single economic or regulatory development. This
may result in greater share price volatility. The composition of the respective Index underlying each Fund is heavily dependent on
quantitative models and data from one or more third parties, and the Index may not perform as intended. The Funds invest in the
securities included in, or representative of, their Indexes regardless of their investment merit, and the Funds do not attempt to
outperform their Indexes or take defensive positions in declining markets. Please read the Funds’ prospectus for specific details
regarding the Funds’ risk profile.
The MSCI EAFE Local Currency Index is a special currency perspective that approximates the return of an index as if there were no currency valuation changes
from one day to the next. The MSCI EAFE Index is a market cap-weighted index composed of companies representative of the developed market structure of
developed countries in Europe, Australasia and Japan. The MSCI EAFE 100% Hedged to USD Index achieves an index return very similar to the MSCI EAFE Index
but with the addition of hedging its currency exposures. The MSCI EAFE Adaptive Hedge to USD Index represents a close estimation of the performance that can
be achieved by hedging the currency exposure of its parent index, the MSCI EAFE Index, to the U.S. dollar, the “home” currency for the hedged index.
WisdomTree Funds are distributed by Foreside Fund Services, LLC, in the U.S. only.
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