When I speak at investment conferences across the country, the subject of the clever but polarizing phrase “smart beta” often comes up. Once the obligatory comments are made about how much people hate the phrase or how hard it is to define, the conversation typically turns to the category of passive investment choices that the term attempts to summarize. For WisdomTree, when we talk about smart beta, what we are really talking about is a new generation of index-based products that empower investors to explore the core of their portfolios in an attempt to generate better risk-adjusted returns compared to traditional benchmarks.
On the international front (EAFE), this means re-examining basic beliefs about whether to take on currency risk in an investor’s core international equity exposure. In recent months, as the dollar has rallied dramatically against both the yen and the euro, interest has turned to strategies that give U.S.-based investors ways to own foreign stocks, while neutralizing foreign currency fluctuations that may move against them. This makes sense.
Currency exposure is a separate and distinct source of risk in an investor’s portfolio. Currency-hedged portfolios give investors a way to benefit from international 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. By examining the historical returns of the MSCI EAFE Index —both with and without exposure to currency—we can examine what happens to the risk/return profile of international stocks when the currency impact is removed. In the table below, we see how significantly the beta of MSCI EAFE is reduced (in blue) when currency is removed from the equation.
For definitions of terms and indexes in the chart, visit our glossary.
If an investor had targeted the local returns of EAFE for the past three, five, 10 or 20 years, the returns would have been higher without the currency exposure than with it. Moreover, currency exposure added several percentage points of incremental volatility to international equity exposure in each period shown above, going back to 1970. And while having the currency exposure may have provided some diversification benefit several decades ago, the correlation between the EAFE currencies and the S&P 500 has been rising in the past decade compared to where it had been over the past 20 or 40 years.
All this raises a question: Should investors be 100% unhedged in their core international equity exposure, especially given the low cost of hedging developed world currencies today with interest rates in Japan and Europe at or below 0%?
One way to help generate higher risk-adjusted returns is by reducing overall volatility. The other is by generating returns that exceed those of a comparable cap-weighting index. In WisdomTree’s case, we have been doing so with several of our broad-based Indexes that have some of the longest track records in the fundamentally weighted indexing space.