The critical message: minimize the risk of “regret.” Regret comes when a choice is made and then the opposite is paraded out day after day, clearly having been “better.”
50/50 Blend with a Foundation in both Currency Exposure and Fundamental Drivers
WisdomTree has such a broad suite of European-focused equity strategies that we believe investors may not even realize the flexibility with which they might more finely tailor their European exposure. Examples include the following:
WisdomTree Europe Hedged Equity Index: On the plus side, this strategy requires all constituents to generate more than 50% of their revenues from outside of Europe. One theme that is being discussed at present: synchronized global growth. These are global firms that happen to have their headquarters in Europe. Currency exposure between the euro and the U.S. dollar is also neutralized, so on the minus side, the returns of this strategy have not benefited at all from the appreciating euro that we’ve seen more recently.
WisdomTree Europe Domestic Economy Index: From a revenue perspective, this is the opposite in that each constituent must derive more than 50% of revenue from inside Europe. On the currency side, it also has exposure to movements of the euro versus the U.S. dollar, and it therefore has benefited from the euro appreciation of late.
Diversification of Geographic Revenue and Currency Exposure
It’s notable that the 50/50 blend of exporters and domestics for European equities arrived very closely at a 50/50 geographic revenue split between inside and outside of Europe. We already know that the currency exposure is split 50/50 due to one index being hedged and the other having the full exposure to the euro’s movements.
Additionally, over the period of live history, we wanted to see if the Sharpe ratio exhibited any advantage to this blend. Typically, hedging the euro versus the U.S. dollar tends to lower overall volatility. However, when the euro appreciates, hedged approaches miss this boost to returns.
Of the different strategies we show, the 50/50 blend of exporters and domestics had, in aggregate, the strongest Sharpe ratio, indicating that the risk/return trade-off was actually better for the blend than for either exporters or domestics alone. This initial track record plus the diversification of revenue exposure and the 50/50 starting point to minimize regret of taking the “wrong” approach to currency exposure all make this blend very interesting, in our view.
We can also see the difference between the one-year cumulative returns versus even the full period returns, as the full story of outperforming/underperforming on the one-year basis was based on the “currency versus no currency” exposure decision. As periods lengthen—and one even sees the start of this impact from September 1, 2015, to December 31, 2017—this gap would be expected to narrow and the risk reduction from hedging at least a portion of an exposure would become more interesting.
This article was republished with permission from Wisdom Tree.