An Actively Passive Currency Hedged Strategy

Thanks in large part to the evolution of currency hedged exchange traded funds as core portfolio holdingns, more investors have become aware of the scurge of currency risk.

With either currency hedged or unhedged ETFs, investors, whether they realize it or not, are making currency bets. A stake in currency hedged ETF equals clearly defined risk in that investor outcomes are better if the U.S. dollar is strong. With unhedged ETFs, a weaker dollar favors investors. Until recently, those were really the only currency bets ETF investors could make.

Dynamically hedged ETFs, such as the WisdomTree Dynamic Currency Hedged International Equity Fund DDWM, give investors the opportunity to enhance management of currency risk. Remove the currency hedging, and DDWM is a pure index (passive) ETF. Even traditional currency hedged ETFs are considered passively managed, but to some market observers, dynamic management of currency risk blurs the line between active and passive management.

“Although this fund tracks an index, its currency overlay resembles an active quantitative strategy. Its currency bets will likely add up to a small performance edge over unhedged and fully hedged alternatives,” said Morningstar in a recent note. 

As we recently highlighted in this space, “If a currency, on a purchasing parity basis, is overvalued relative to the dollar, the DDWM can move closer to being fully hedged. Likewise, if the dollar is overvalued compared to other currencies, hedging becomes less useful. Hence the phrase “dynamic currency hedging.” A simplistic view of DDWM is that it splits the difference of making a strong dollar bet with a currency hedged ETF and a bullish foreign currency bet with an EAFE or Europe ETF.” http://www.benzinga.com/trading-ideas/long-ideas/16/05/8033606/meet-one-of-this-years-most-successful-new-etfs

An alternative view is that an ETF like DDWM does not force investors to make the all-in commitment of a currency hedged or non-hedged ETF. There are benefits to DDWM's strategy.

“Currency fluctuations are a considerable source of risk in an international-stock portfolio. During the past decade, they accounted for nearly a fifth of the MSCI EAFE Index's total volatility. These movements tend to wash out over the long term and don't have a big impact on stock returns. Because this source of risk is not well compensated over the long term, there is a case for hedging it, especially for investors who don't have a view on currency movements,” adds Morningstar.

Data suggest investors like the idea of dynamically hedging currency risk. DDWM is just five months and already has $241.5 million in assets under management, easily making it one of this year's most successful new ETFs.