Explore the Core with International Small Caps: Hedged or Unhedged

by Luciano Siracusano III, Chief Investment Strategist on June 8, 2015

 

In recent months, as the dollar has rallied dramatically against both the yen and the euro, investor interest has turned to strategies that give U.S.-based investors ways to own foreign stocks while mitigating the risk that foreign currency fluctuations will move against them. This makes sense. Currency exposure is a separate and distinct source of risk in an investor’s portfolio. International hedged portfolios give investors a way to benefit from equity performance without being penalized by—or rewarded for—movements in foreign currencies.

Over the last 20 years, exposure to developed world currencies has not added to overall stock returns, although it has added volatility, based on comparisons between the unhedged and local returns of the MSCI EAFE Index. By examining the historic returns of the MSCI EAFE Small Cap Index—both with and without exposure to currency—we can also examine what happens to the risk/return profile of international small-cap stocks when the currency impact is removed.

Figure 1: International Small Caps 1 Had Lower

International Small Caps Beta  International Small Caps

Using the beta statistic measured against the S&P 500 Index—one of the most widely followed for any U.S. equity investor—we can see that the MSCI EAFE Small Cap with no currency exposure exhibited a value below 1.00, meaning that it had lower market risk than the S&P 500 Index, across all time periods displayed in figure 1. The MSCI EAFE Small Cap with currency—an index of the same underlying equities—showed a beta at or above 1.00 when compared with the S&P 500 Index over the same time periods.

Figure 2: Currency Exposure Significantly Raises Volatility

Currency Exposure Significantly Raises Volatility

Over the last 10 years, the incremental risk from having the currency exposure added about 3.2% per year to the annualized volatility; yet the currency exposure added nothing to the total return of the portfolio (it actually amounted to nearly a 1 percentage point annualized drag on the index). This raises a natural question: why take on risk to an “asset class” if there is no expected return?

The answer may be that developed world currencies are not really an asset class at all. Therefore, going forward, investors may be interested in targeting local market returns—through a currency-hedged approach. In the case of developed world small-cap stocks, the evidence suggests that investors might improve their risk profiles by doing so.

Introducing the WisdomTree International Hedged SmallCap Dividend Index

WisdomTree recently launched a new index that measures the performance of international small caps while mitigating foreign currency risk. The WisdomTree International Hedged SmallCap Dividend Index (WTISDIH)—a broad measure of developed world small-cap companies—hedges fluctuations in foreign currencies against the U.S. dollar. The cost to hedge, essentially the annualized difference in one-month interest rates between the U.S. and each targeted market, was 0.46%2 as of April 30, 2015.

One way to generate higher risk-adjusted returns is to reduce risk, which, as we have shown, may be achieved by hedging currency exposure. The other way is to increase returns. This may be achieved by weighting equity markets by measures other than market capitalization. On this point, it’s important to note that WisdomTree has been illustrating what happens when one weights equity markets based on dividends for nearly a decade now. In May 2006, WisdomTree launched the unhedged version of this Index when it introduced international small-cap investing to the ETF industry. The currency-hedged Index, WTISDIH, and the unhedged WisdomTree International SmallCap Dividend Index (WTISDI) share the same selection and weighting rules. Constituents are selected annually based on their market capitalizations; they are weighted once a year based on the U.S. dollar value of the cash dividends they have paid to investors over the prior year. The Indexes are rebalanced each year in June, and country and sector exposures are capped at 25% at the annual rebalance.

So the performance of the underlying stocks—with currency risk—is already known. Since its inception in 2006, WTISDI has generated returns that have exceeded those of the capitalization-weighted MSCI EAFE Small Cap Index by roughly 170 basis point (bps) over the same period.3

For investors interested in the strategies, the WisdomTree International Hedged SmallCap Dividend Fund (HDLS) is designed to track the performance of the WisdomTree International Hedged SmallCap Dividend Index before fees and expenses. For more information on the exposures of this Fund, please click here.

1International Small Caps refers to the MSCI EAFE Small Cap Index.
2Source: Bloomberg, as of 4/30/2015.
3Source: Bloomberg, as of 3/31/15.