Morningstar Magazine - April/May 2015 - 41

EXHIBIT 2

U.S. dollar). WisdomTree Europe Hedged Equity
HEDJ rose 6.5%, significantly outperforming
the category average of negative 7.3%.

Hedging exposure to major currencies
is fairly inexpensive.
To illustrate this point, we compared the returns
of a market-cap-weighted MSCI index denominated in local currency versus its corresponding
100% Hedged to U.S. Dollar Index. These
hedged indexes reflect the return that can be
achieved by hedging the currency exposure
of a market-cap-weighted index with one-month
foreign currency forward contracts, rebalanced
monthly. Generally speaking, the execution costs
related to these forward contracts are negligible,
as these products are extremely liquid.
While forward contracts serve as a hedge, they
also reflect the cost of hedging, which is the
short-term interest-rate differential between two
currencies. If short-term rates in a foreign
currency are higher than they are in the United
States, the hedge will have a cost. But if the
reverse is true, the hedge would result in a gain.
It is this cost to hedge that drives the difference
in performance between the returns of a
100% hedged index versus the returns of an index
denominated in the local currency.

Cheap to Hedge By subtracting an index's local currency returns from its U.S. dollar
hedged returns, we estimate the costs of hedging, which have been inexpensive.
Return (%)

Annualized Return (%)

2014

2013

2012

5-Yr

10-Yr

MSCI EAFE 100% Hdg USD

5.7

26.7

17.5

7.9

6.0

MSCI EAFE Local Currency

5.9

26.9

17.3

7.8

5.3

Cost to Hedge

0.3

-0.2

-0.1

-0.7

Source: MSCI Data as of 01/31/2015

EXHIBIT 3

Lower Volatility Currency-hedged strategies can lower the volatility of an international-equity portfolio.
Annualized Standard Deviation (%)

Max Drawdown

3-Yr

MSCI EAFE 100% Hdg USD
MSCI EAFE USD

5-Yr

10-Yr

End Date

9.7

11.8

14.4

54.6

03/2009

13.0

16.6

18.2

60.4

03/2009

Source: MSCI Data as of 01/31/2015

EXHIBIT 4

Mean Reverting The return gap between currency-hedged and unhedged indexes
narrows over time.
Annualized Return (%)
3-Yr

The MSCI EAFE Index is a market-cap-weighted
index composed of large- and mid-cap stocks
across 21 developed markets, excluding the United
States and Canada. Over the past two years,
the cost to hedge the MSCI EAFE's foreigncurrency exposure was 30 basis points a year,
detracting from returns ( E X H I BI T 2 ). But at times
when short-term rates were lower in Japan,
or Europe, than in the United States, the hedge
added to returns (respresented by a negative
number), which was observed over the past five
and 10 years.
Hedging can reduce volatility.
For a U.S.-based investor, a currency-hedged
strategy can reduce the volatility of an international-equity portfolio ( E X H IB I T 3 ). This may be
partly attributable to the fact that the U.S. dollar
is considered a safe-haven currency and tends
to rise when risk aversion is high. In other words,
when volatility spikes in global markets, the

MSCI EAFE 100% Hgd USD
MSCI EAFE USD

5-Yr

10-Yr

Since 01/31/2001

15.9

9.2

6.2

2.9

9.3

6.4

4.7

3.9

Source: MSCI. Data as of 01/31/2015.

performance of an unhedged internationalequity fund can be negatively affected by both
falling international-equity markets, as well
as a rising U.S. dollar. During the 2008 global financial crisis, the unhedged MSCI EAFE Index
had a maximum drawdown of 60.4%, whereas the
hedged version declined by 54.6%.
Reasons to Not Pursue a Hedged Strategy

transparent about their monetary policies
and their goals, so it hasn't been that difficult
to predict the performance of the yen and
euro against the U.S. dollar. However, central
banks can suddenly change their mind.
In January, for example, the Swiss National Bank
surprised global markets when it decided to
drop its exchange-rate cap, which sent the Swiss
franc soaring.

Knowing when to move in and out of a
currency-hedged strategy requires an ability
to forecast currency movements.
Over the past few years, central banks in the
United States, Japan, and Europe have been fairly

These strategies can also result in a higher
tax liability.
There are also tax issues to consider. Moving
in and out of hedged and unhedged strategies
can result in capital gains. In addition,

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