“The Value of Value”

“Once you adopt a Value investing philosophy, any other investment behavior starts to seem like gambling.”

Seth A. Klarman, “Margin of Safety”

51NcUB2HTxL._SX336_BO1,204,203,200_

 

It took me a few days to finish a letter written to fellow investors by Mark Yusko, Morgan Creek Capital Management, a money manager with $3B AUM. As part of the 66 pages long “Q2 2016 Market Reveiw and Outlook” of the company, this letter is 30 pages long, with the title of “The Value of Value”.

The reason I love this letter is the timing of it. In the past few months, I was struggling with which path of investment I should choose for the rest of my life. I was indulged in day trading for some times. I read some books about value investing, but the whole concept is still vague for me. Just a few days ago, a friend who is a beliver of value investing, had a chat with me and strongly suggested me to go the value investing way. Then I noticed this letter on Twitter (link).

Mark Yusko is the founder, CEO and CIO of Morgan Creek Capital Management. It was very interesting that the source I know him was from a podcast of NPR Money about crude oil (link). He is the only one who admitted to the public that he is a “speculator of oil”, according to the interviewers. When his name appears on Twitter, it drew my attention immediately.

Mark’s letter has a through review of Seth A. Klarman’s value investing philosophy. Some depicts are from Klarman’s famous book “Margin of Safety” , some are from Klarman’s letters to his fellow investors at Baupost. Mark’s letter systematically reviewed Klarman’s thoughts from 6 aspects: (1) philosophy; (2) mindset; (3) process; (4) team; (5) client; (6) culture. If someone wants to know Klarman’s value investing philosphy, this lettter is absolutely a piece of article worthy to be read back and forth.

There are many good examples and stories in the letter. One of them I love very much is about cash as an investment. The letter wrote (on page 29), a concerned client called Klarman to express his displesure that the Fund was so heavily invested in cash and asked “why I am paying you 2% and 20% for you to hold cash?” In a very calm manner, Klarman replied something along the lines of, “if you think you are paying me those fees to hold cash, you should redeem immediately. You are paying us 2% and 20% to know when to hold cash and when to invest, when to take risk and when to retreat to the sidelines. You are paying us those fees to know when is the best time to press the best possible risk/reward. But since you fee this way, I will waive the usual lock-up restrictions and wire your cash to you in the morning.” What a wise explanation of the value of holding cash and the value of professional expertise!

Klarman’s book is out of circulation since its first print of 5000 copies. Now it is sold on Amazon with a price tag of over $1,000, kind of like a collectible. But the content could be found on internet due to its popularity. It is on my reading list for this week.

 

Advertisements

Fintech Toronto Event

Today I participated the Fintech Toronto event at downtown Toronto. This is the first time I join this kind of event. It was mind-openning, fun, and inspiring. I guess there are about 150 or more people attended this event.

FintechTo Event

The event featured 3 speakers from 3 Fintech companies: FinanceIt, Honk, and OANDA. All of the 3 speakers’ sharing are facinating.

FinanceIt is a consumer finance comany, focused on home renovating loans. The company originally started from 2007. Along the way, they have tried many market niches, overcame all kinds of unexpected obstacles. Theire story let me know start-up is never easy.

Honk provides solutions for drivers who want to find an ideal parking spot. This is really a big issue each time when I am going to downtown Toronto. The Honk app can even offer discounts. Drivers can pay on cell phone. Definiate I will try it the next time. Michael, the enterpreneur who created this start-up company, has successfully created, operated and sold his first company. What I learned from Michael is, good business model means you can solve a problem for people. First of all, you should find out where the problem is.

OANDA is an online forex trading platform. Although I don’t use OANDA’s platform(I use IB), I have known it for a while. The company’s founder, another Michael, compares starting up a business and work for a bank. The former only suitable for those who have enterpreneurship, vision, and hard working. If your goal is to make big money, you’d better go to work in a bank, this is his advice.

Will I start up a business someday? Maybe! It has never been on my option list, but why not?

 

 

 

 

 

 

 

 

 

Trading US Dollar with ETFs: A Canadian Perspective

The US Dollar Index generally kept an uptrend since May (as shown in the chart below), although it had some zig-zags. Last friday, the US dollar had a sharp drop due to disappointed GDP release. There are sevaral reasons to belive that the US dollar will pick up the momentum, so the drop last week provides opportunities to buy. At the same time, oil price kept going down, it may boost the uptrend of USD/CAD. From a Canadian trader’s perspective, if you want to long the us dollar, there are at least 4 ETFs available to choose.

US Dollar Index 2016-08-01

USD:CAD 2016-08-01

1, Comparisons of 4 ETFs

The four ETFs can be classified into two groups: (1) US dollar against a basket of currencies, two ETFs are UUP and USDU; (2) US dollar against Canadian dollar, two ETFs are FXC and DLR/DLR.U. Here are some comparisons about these 4 ETFs.

  USD against a basket of currencies USD against CAD
  UUP USDU FXC DLR/DLR.U
Fund Name PowerShares DB US Dollar Index Bullish Fund WisdomTree Bloomberg U.S. Dollar Bullish Fund Guggenheim CurrencyShares® Canadian Dollar Trust HORIZONS

US DOLLAR CURRENCY ETF

Issuer Invesco WisdomTree Guggenheim Horizons
Exchange NYSE Arca NYSE Arca NYSE Arca TSX
Inception Date 02/20/2007 12/18/2013 6/21/2006 APRIL 06, 2011
Net Assets 829.9M USD 246M USD 207.8M USD 69.9M CAD
Benchmark Deutsche Bank Long US Dollar Index (USDX®) Futures Index – Excess Return™ Bloomberg Dollar Total Return Index CAD.USD USD.CAD
30 Day ADVolume 1,204,479   57,039  
Management Fee 0.75% 0.50% 0.40%CAD 0.45%
Holdings DX futures US Treasury Bills and Short Currency contracts 100% Canadian Dollar US Treasury Bills and Cash

2, Comparisons of the benchmarks of UUP and USDU

2.1 UUP tracks the US Dollar Index (USDX). The introduction of this index see here. It is created in 1973 to reflect US’ trading relationship and only adjusted once when the Euro was introduced.The index is consisted by 6 developed markets currencies. Euro accounts 57.6% weighting, so the index is highly correlated with Euro. The futures based on this index is trading at ICE futures US.

2.2 USDU tracks the Bloomberg Dollar Total Return Index (BBDXY). This index could be regarded as an optimization of the US Dollar Index. It is based on most current global goods trade and currency trade. Compare to USDX, BBDXY deleted Swedish Krona and Swiss Franc, added 5 new currencies: Mexico Peso, Australia Dollar, Brazil Real, South Korea Won, and China Yuan. It is broader, more representative, and less concentrated.

2.3 One major difference of the two indices is: the components and weightings of USDX is static, while those of BBDXY is rebalanced annually according to the global trade and currency trade.

  Currency U.S. Dollar Index (USDX) Bloomberg Dollar Total Return Index (BBDXY)
Euro EUR 57.6% 31.8%
Japanese Yen JPY 13.6% 18.5%
British Pound GBP 11.9% 9.5%
Canadian Dollar CAD 9.1% 11.5%
Swedish Krona SEK 4.2%  
Swiss Franc CHF 3.6%  
Mexico Peso MXN   9.9%
Australia Dollar AUD   6.1%
Brazil Real BRL   2.1%
South Korea Won KRW   3.4%
China Yuan CNH   3.0%

3, Individual fund analysis

3.1 UUP – PowerShares DB US Dollar Index Bullish Fund. This fund’s underlying index is USDX, which is highly correlated with Euro. This fund is very liquid.

3.2 USDU – WisdomTree Bloomberg U.S. Dollar Bullish Fund. The fund holds short term US treasury bills and sell 10 foreign currencies future contracts. USDU’s performance is generally close to UUP but differs from time to time slightly.

3.3. FXC – Guggenheim CurrencyShares® Canadian Dollar Trust. This fund is for investors who take a bearish outlook of USD against CAD. It is just opposite to DLR. If an investor believe USD will appreciate against CAD, he or she should short FXC.

3.4 DLR – Horizons US Dollar Currency ETF. This ETF is for Canadian investors who has a bullish outlook of USD against CAD. It is also a widely used currency conversion tool in Canada. The fund has both CAD and USD version, so it is very convenient for investors.

4, Considerations of trading these ETFs

4.1 Trading against a basket of currencies or an individual currency. Generally speaking, trading against a basket of currencies is less volatile than against individual currency.

4.2 Watch the related central bank policies. UUP is highly correlated to ECB. USDU has higher weighting on JPY.

4.3 Trading directions. UUP is bullish on USD, it also has an inverse version UDN. FXC is bearish on USD, DLR is bullish on USD.

 

 

 

 

WisdomTree Canada’s ETFs Review

On July 14 2016, WisdomTree announced the launch of its first suite of ETFs in Canada. These products relfected some most latest trends of the ETF products developments: multi-facctors, dynamic currency hedge. It also provides a comprehensive geographic coverage: US, Europe, and International. Here are some summaries of the products and my comments.

Screen Shot 2016-07-18 at 11.05.29 AM

Source: WisdomTree Canada’s webiste https://www.wisdomtree.ca

1, US Quality Dividend Growth ETFs DGR/DGR.B/DQD

1.1 The index methodology/investment universe starts from a base index “WisdomTree Dividen Index (DI)”. DI has several criteria: (1) US headquartered companies; (2) listed on NYSE or NASDAQ; (3) pay regular cash dividends on common stock shares; (4) market cap above US$ 100 million; (5) daily trading volume above US$ 100,000.

1.2 US Quality Dividen Growth Index has some further requirements: (1) market cap above US$ 2 billion, which is much higher than the DI requirement; (2)Earnings yield higer than dividend yield.

1.3 US Quality Dividen Growth Index factor weithging rule: (1) 50% weighted to the rank of long term earnings growth; (2) 25% weighted to the rank of historical 3 year average ROE; (3) 25% weighted to the rank of historical 3 year average ROA. We can conclude that it’s 50% to the past and 50% to the future, overall it’s focused on earnings growth.

1.4. Top 300 hundered stocks are chosen. Any single sector’s exposure is capped by 25%.

1.5 The holdings only cover 7 sectors and concentrated in 4 sectors: industrial 20.60%, consumer discretionary 19.77%, information technology 19.35%, consumer staples 18.23%. Financials only account 3.41%. Three industries are missed: energy, utilities, and telecom. (While in 2016, energy and utilities are best performers in US market).

1.6 Dynamic hedging strategy: based on 3 factors of the currency pair of USD/CAD: (1) momentum, (2) interest rate differentials, and (3) value, the hedge ratio could be 0.0.0%, 16.67%, 33.33%, 50%, 67.67%, 83.33% or 100.00%

1.7 Based on the same index, while different currency hedging strategies, the company provides 3 version of the products: (1)DGR, no currency hedge, unit holders are exposed to the fluctuation of USD/CAD; (2)DGR.B, fully hedged, clients will only get the return of the index itself; (3) DQD, dynamically hedged, a strategy with its effectiveness hasn’t been proofed by the market. These three version provide good optionalbility for investors and advisors.

1.8 This product’s index methodology and numbers of holdings let me recall another similar product: GSLC, Goldman & Sachs US ActiveBeta Large Cap ETF, while the latter uses 4 different factors: value, momentum, quality and low volatility. GSLC has 400 holdings. GSLC is listed in US, so it has no currency hedge necessity.

2, US High Dividend Index ETFs HID/HID.B

2.1, The index is derived from the base index DI. A few more criteria were added to filter the stocks in the DI investment universe: (1) market cap above US$ 2 million; (2) average daily trading volume above US$ 200,000. Then the component companies rank in the top 30% by indicated annual dividend yeild are selected.

2.2, Current holdings cover all 10 sectors (which is different from the US Quality Dividend Growth ETFs), the first 3 sectors are: consumer staples 17.73%, energy 15.65%, financials 13.74%. As the index methodology focused on pure curren dividend payments, growth factor is not considered. Its top ten holdings are all traditional big names, no technology companies, this is quite different from DGR/DGR.B/DQD.

2.3, This fund holds 431 stocks, 130 more than DGR/DGR.B/DQD.

3, WisdomTree International Quality Dividend Growth products IQD/IQD.B/DQI

3.1 The base index WisdomTree International Equity Index’s screening criteria. It covers dividend paying companies in Japan, the 15 European countries, Australia, Israel, New Zealand, Hong Kong or Singapore. Some screening criteria: (1) annual dividen payouts at least US$ 5 million; (2) market cap at least US$ 100 million; (3) average trading volume at least US$ 100,000.

3.2 The WisdomTree International Quality Dividend Growth Index is derived from the base index and comprises 300 companies from the base index. It filtered furthur by some more strict criteria: (1) market cap at least US$ 1 billion; (2) earnings yield greater than the dividend yield;

3.3 Weighting method is the same as US Quality Dividend Growth ETFs. Eligible companies are ranked using a weighted combination of three factors: 50% weighted to the rank of long-term estimated earnings growth, 25% weighted to the rank of the historical three-year average return on equity, and 25% weighted to the rank of the historical three-year average return on assets. Top 300 companies by this combined ranking will be selected for inclusion. Currently it holds 220 companies.

3.4  Based on the index, there are 3 dfferent version of ETFs: (1) unhedged IQD; (2) fully hedged IQD.B; (3) dynamically hedged DQI. Dynamic hedging strategy: based on 3 factors of the currency pair of USD/CAD: (1) momentum, (2) interest rate differentials, and (3) value, the hedge ratio could be 0.0.0%, 16.67%, 33.33%, 50%, 67.67%, 83.33% or 100.00%.

3.5 Sector breakdown. 8 sectors are covered. Highly concentrated on Consumer Discretionary, Consumer Staples, Healthcare, and Industrials. No energy companies.

3.6 Country allocation. 20 countries are covered. Countries have more than 10% allocaions are (1) UK 19.61%; (2) Switzerland 12.23%; (3) Netherland 10.98%; (4) Japan 10.38%.

4, WisdomTree Europe Hedged Equity Index ETF EHE

4.1 Index methodology. The index is derived from the base index WisdomTree International Equity Index and add some criteria: (1) listed in Europe exchanges, UK is not included; (2) Companies must be domiciled in Europe and traded in Euros, so the hedge is only related to EUR/CAD; (3) derive at least 50% of their revenue from countries outside of Europe, this is a very special and critical requirement; (4) annual dividend payout at least US$ 5 million; (5) market cap at least US$ 1 billion.

4.2 Sector breakdown. It consists of 9 sectors and the top 3 sectors are: (1) consumer staples, 19.66%; (2) industrials, 17.85%; (3) consumer discretionary, 17.43%.

4.3 Country allocation. It covers 10 euro zone countries, France is the largest component, accounts for 25.24%; Germany is the second largest with 25.13%.

5. Some comments

5.1 It is very good to see a major US player comes to the Canadian market. There are some new entrants this year, but not as established as WisdomTree. It’s positive for the industry’s long term development.

5.2 Distribution is the key. Asset gathering is very critical for new ETFs. In Canadian market, except some first mover (such as iShares and BMO), I belive big banks and insurance companies will get the lion’s share in the ETF market gradually, because they have superior distribution capability. New and small ETF issuers will be struggling with asset gathering. We have already see the low AUM and trading volume of the products of small issuers.

5.3 Time of entry. The time WisdomTree launched their products is just when US markets reaches new highs. Europe is still facing challenges of more countries will exit European Union. Investors are concerned about the global equity markets. As an investor, I will not add any long term positions at current price. If the market has material correction in the second half of this year, asset gathering will be more difficult. But I belive WisdomTree has already taken in all these headwind factors.

Opportunities in China’s Securities Markets

Today I attened an event about the introduction of China’s Securities Markets hosted by New Horizon Career Club. Mr. Yong Wong, Chife Risk Investment of Everbright Securities of China, introduced the latest development of China’s securities market. Hundereds of young financial professionals and students from the University of Toronto joined the meeting. This is really a wonderful event that I learned a lot.

Securities Markets In China

My main takeaway from this event is that you should be a subject matter expert in a specific area if you want to advacne your career into a new stage. It may be portfolio management, ETF products, derivative products, or trading. The global financial markets are getting integrated, capitals and human resources are moving endlessly. There are always opportunities, but they are only available for those prepared.

S&P Dow Jones ETF Masterclass Event

On Thursday, June 23 2016, I attended the S&P Dow Jones Indices ETF Masterclass at downtown Toronto. This is the second year SPDJ hosts this kind of event and I attened both. Speakers are mainly from indices provider (SPDJ), ETF issuers, ETF strategists. The event was very well orgainized and informative.

IMG_4328

Although I learned a lot at the product and technique level, for me the most important takeaway from this event is the confidence of the direction I have choosen: to be a subject matter expert of ETFs. We are fortunate to be in the North America where the ETF markets are more advanced than the rest of the world. There are more than 2500 ETFs, 170 providers and 800 strategists combined in US and Canada. The ecosystem is well developed. At the same time, the markets are still developing rapidly and have lots of potential. The future is bright and exciting.

To achieve the goal of becoming an ETF expert, at least 2 layers should be done.

Layer 1, digest the products. This is very time consuming but it is absolutely essential. You need to read through the documents, understand the methodologies. A good way to enhance understanding is to compare similar products and find out their differences.

Layer 2, use ETFs to build portfolios. After you mastered the characteristics of different products, you’ll move to the state of utilizing them. Build a low cost and well diversified ETF require knowledge, discipline and patience. There are many lures and traps. Simplicity is the ultimate sophistication.

These are the focus of my self-learning plan in the second half of 2016.

CSTA Annual General Meeting Takeaways

Today I attended the Canadian Society of Technical Analysts (CSTA) 30th general meeting at Sheraton Toronto. This is a great event that I got the opportunities to meet masters and practitioners of technical analysis, listened to their thoughtful sharings. It happened that I was sitting next to Mr. Ron Meisels, the founder and first President of the Canadian Society of Technical Analysts (CSTA). I also talked to Mr. Larry Berman, he won the most awards today due to his distinguished contribution to the technical analysis in Canada.

A few takeaways from the event:

IMG_4319

1, Technical analysis can explain something fundamental analysis cannot. This is true becasue fundamentals will not change as frequent as prices. If you can master both, you will be able to understand market behaviors more convincingly.

2, CFA + CMT. Mr. Larry Berman says, CFA helps you to get the job, CMT helps you keep the job. I totally agree with his point that a designation of technical analysis will sharpen your skills and boost your career.

3, Technology development make it possible for more people to utilize technical analysis. 20 years ago, due to technology limitation, general public don’t have the  convenient access to technical analysis. Today we have high speed internet, real-time data of global exhanges, customized screening tools, high performance computers can produce any technical analysis as you want. Sophisticated trading platforms now are available to common individual investors. All of these will make technical analysis more prosperous in the coming years!

4, Technical analysis is not only technics, but also arts. With the same chart, different technician may get different conclusions. You still need experience and intuiton to your final decisions.

5, Success comes from hard working. Success doesn’t come by chance. Many successful technical anaysts I meet today, they worked in the field for decades, from 6:00am to 12:00pm day after day. This let me recall a principle of 10,000 hours. If you want to be a specialist in any field, you need at least 10,000 hours deliberate practice.

 

Adaptive vs Dynamic: Comparison of two new currency hedged Japan ETF

Probably the majority of investors would agree that currencies are the most difficult markets to forecast. This year, the movement of Japanese Yen and Euro against US dollar good examples of currencies unpredicatability. Although Japan and Euro Zone are in the negative interest rate territory, US is going to increase interest rate, Yen appreciated 13.0%,  Euro appreciated 4.4%, against USD respectively. They are out of the majority’s predition.

JYP & EUR

At the beginning of 2016, currency hedged ETFs evolved into a new stage. Almost at the same time, iShares and WisdomTree launched their new currency hedged ETFs, and the ideas are very similar. On Jan. 5 2016, iShares launched 3 “Adaptive” currency hedged ETFs: DEFA (iShares Adaptive Currency Hedged MSCI EAFE), DEZU (iShares Adaptive Currency Hedged MSCI Eurozone), DEWJ (iShares Adaptive Currency Hedged MSCI Japan). On Jan. 7 2016, WisdomTree launched 4 “Dynamic” currency hedged ETFs: DDWM (WisdomTree Dynamic Currency Hedged International Equity), DDLS (WisdomTree Dynamic Currency Hedged International SmallCap Equity), DDEZ (WisdomTree Dynamic Currency Hedged Europe Equity), DDJP (WisdomTree Dynamic Currency Hedged Japan Equity).

By comparing DEWJ and DDJP, we can know more about how these new currency hedge strategies work.

DEWJ vs DDJP

From the table above, we can find that two funds are quite similar in almost all aspects. The major difference is the hedge ratio options: DEWJ has only 5 fixed options, while DDJP can be anywhere from 0 to 100%. Currently, DEWJ hedged 75% of its underlying assets, while DDJP hedged slightly above 50%. Due to the strong appreciation of Japanese Yen in June, both funds forward contracts (short Yen long USD) lose money.

Another notable point is that both funds are very small by net assets. In the iShares Japan fund series, EWJ is giant with net assets 14.7 billion, HEWJ (the fully hedged version of EWJ) has a net assets of 610 million, DEWJ (the adaptive hedged version of EWJ) has only 3.3 million. In the WisdomTree family, DXJ (fully hedged) has 7 billion, while DDJP has only 4.5 million. In the long run, if these adaptive/dynamic strategies really work, these funds will gain popularity.

 

 

 

 

 

Shall Smart Beta ETF Issuers Disclose Their “Secret Formula”?

This week I attended the “Exchange Traded Forum 2016” in Toronot. The event was fabulous. Industry elite from Canada, US and Europe shared their thoughts and visions about ETFs. Hudreds of advisors and ETF practioners participated the two day event. It is absolutely a grand feast for ETF lovers like me.

One small topic drew my special attention. It’s about if the smart beta ETF issuers should disclose their indexes, detailed methodologies, or we can also call it “secret formula”. During a panel discussion about smart beta in the first day’s meeting, the panelist from a smart beta issuer introduced their smart beta funds. He repeated several adjectives related to their funds: rule-based, multi-facotr, quantitative. But he was challenged by other panlists by a series of questions: (1) is this fund actually an actively managed fund wraped in a ETF? (2) Does the fund have a “pilot” or it is “autopiloted”? (3) By what degree the rule based fund manager play an active role in stock picking? (4) Since it is rule based, why no index disclosed? Is there a black box?

These questions are just what I want to ask if I have the chance. When I read that issuer’s ETF prospectus one year ago, question marks arised. The fund claimed it is rule based, but I didn’t see any index or detailed methodolgy of the calculation of the stock weighting allocation.

The panelist answered: (1) We are rule-based, but we also use fund manager’s discretion; (2) we can create an index, but it is not requried by the current regulation. (3) We save the cost of indexing (generally this work is outsourced from index providers) so that we can benefit our clients. (4) We have significant distribution capability (if my understanding is not wrong, he may imply that the lacking of index is not a issue).

Interestingly in the second day’s meeting, another speaker from the US mentioned this discussion. He said he agrees with the panelist’s standpoint and believe no-indexing or self-indexing (i.e. don’t rely on index providers) may be a industry trend due to its cost saving benefit.

My personal perceptions in regards to this discussion are two-sides:

1, On the “pro” side, what the ETF issuer panelist had said are facts. On the fund’s webiste, it clearly notes “Key differentiators of the ETF include professional money management – no index”. Although not every actively managed ETF can provide an index, most of the real rule-based quantitive ETFs can formulate their indexes. For these non-traditional ETFs, it is not mandatory to disclose the detail of methodology. This is also common in the US, especially among some newly launched small smart beta ETF providers.

2, On the “con” side, I want to say transparency is a lable of the ETF industry, and one of the sources of the fund’s competitiveness, although it also means cost. An example is Goldman Sachs’ Active Beta US Large Cap ETF (symbol GSLC). It is rule-based, quantitative and multi-factor. It also provide “target weight buffers”, which means fund manager has some discretionary authority. The fund disclosed detailed calcaulation methodologis of how the weigtings are allocated amongh three factors. It is trasparent,  persuasive and representing the high standard of the industry practice.

 

 

 

 

Currency Hedging: 0%, 50%, 100% or Dynamically

Currency factor played a critical role in regards to the porfolio rate of return. Sometimes its impact exceeds the underlying asset itself. So it’s no wonder currency hedging concepts and related ETFs are so popular these years. Let’s take Japan equity as an example, in terms of the treatment towards currency exchange rate risk, there are at least 4 versions of ETFs (let’s put aside the difference of underlying indices): unhedged, 50% hedged, 100% hedged, and dynamically hedged. Naturally a string of questions arise: How should we look at currency exchange risk? Why currency heding ETFs are so popular in recent years? What kind of hedging strategy is the best?

1, Currency exchange rate risk is everywhere

I learned this from personal investment experiences. Currency is affecting our porfolio return from several ways:

– Commodity prices are affected by pricing currency. I invested GDX for a while, a gold miners ETF. As gold price are denomiated in U.S. dollars, the price of GDX is negatively correlated with U.S. dollar index.

– International equity prices are affected by the currency exchange rates. I invested EWP, a Spain ETF issued by iShares. I have double layer exposure to currency risks: I resides in Canada and Canadian dollar is my income tax reporting currency, so the CAD/USD matters to me; EWP is denominated in U.S. dollar but Spain uses Euro, so USD/EUR matters too. If tax implication (such as withholding tax) is considered ,this kind of investment is complicated for retail investors.

– Company’s income sources are affected by the currency exhange rates. I invested BEP.UN, a LP unit trated on the Toronto Exchange. In 2015 its unit price decreased sustantially, so I listened its conference calls. The company’s income come from several places: Canada, U.S., Europe, and Brasil. The sharp devaluation of Brasilian Real and the gloomy outlook of Euro dragged the valuation of BEP.UN. If you don’t look into the details of the company income’s geographical distribution, you won’t know why the share price changes.

So my personal takeway from thoese experiences and lessons are, always consider the currency factor your portfolio may have. Try to dig a few layers further to know how your holdings will be affected by currency factor. This is very important.

2, Preconditions of Currency Hedging ETFs

Currency hedging is a risk management tool. It is used with cost and have some preconditions:

– Currency pairs are free float and highly liquid. If a currency such as Chinese RMB Yuan is not free float, it is very difficult or expensive to adopt currency hedge strategies.

– Foreign currency’s interest rate is around zero. This will eliminate the interest rate difference factor and make the hedging simplified. Otherwise there is a delivery of interest rate difference between the two parties. If the foreighn currency’s interest rate is very high, such as India, the hedging gain cannot cover the interest rate difference, thus make the hedging infeasible.

So from the view angle of the U.S., we can see most of the currency hedging ETFs are invested in Japan, Europe.

3, Which hedging strategy is the best

Currency hedging is a very good example of product innovation in the ETF industry. Since 2006 WisdomTree launched the first currency hedging ETF, DXJ, the evolution of currency hedging is never stopped. In 2005, IQ index launched 50% hedged ETFs. In the beginning of 2016, WisdomTree launched dynamic hedging ETFs. Let’s take Japan as the example again, there are 4 different versions of Japan total market equity ETFs: unhedged EWJ (iShares), 50% hedged HFXJ (IQ Index), 100% hedged DXJ (WisdomTree), and dynamically hedged DDJP (WisedomTree).

Screen Shot 2016-02-09 at 3.55.58 PM

I’d like to use a simplified illustration to explain my understanding of those strategies.

Currency Hedging

We can see there are 4 strategies altogether. Among those 3 are static strategies and 1 is dynamic.

– Unhedged. This strategy means you are fully exposed to the exhange rate risk. You may suffer from the depreciation of the foreign currency you invested, while you may aslo benefit from the appreciation of the foreign currency. If you have no idea about the trend of the foreign currency exchange rate and are willing to take the risk, this is your choice.

– 50% hedged. You still have no idea with the exchange rate direction but want to do something. 50% hedging is like a straddle strategy in options. You pay a bit of cost to participate the exchange rate movements.

– 100% hedged. You don’t want to participate the game of currency movement. You just want to play the pure game of the underlying assets themself. 100% hedgeing strategy filtered the currency factor and make it a pure game. Or if you think the foreign currency will depreciate and you need the protection, this is your choice.

– dynamically hedged. WisdomTree uese a rule based method to decide how much should I hedged at any given time. The formula watchs three factors: interest rate, momentum, value, which are equally weighted. Under this method, the ratio of hedging could be any percentage between 0 to 100%. This is why it is called dynamic.

Debates about the effectiveness of currency hedging have never been stopped. It’s not easy to say which strategy is overwhelmingly superior than the rest. From the 4 ETFs chart above, we can see that due to recent appreciation of Japanese Yen, unhedged EWJ outperformed 50% hedged HFXJ and 100% hedged DXJ. With the direction of exchange rates become more and more difficult to predict, maybe the 50% or dynamic strategis are better choices. As those two funds are rolled out a very short period of time, we still need to watch for some time.

Abstract in Chinese / 中文摘要

在ETF领域,货币对冲是近年来的热门话题,包含货币对冲策略的ETF呈现爆发式增长,并在吸引资金方面表现抢眼。与此同时,货币对冲策略本身也在不断演进,令投资者面临多种选择。以投资日本的ETF为例,从货币对冲的角度看至少有4种类型的基金:(1)完全不采取任何对冲策略的,比如iShare的EWJ;(2)采取50%对冲策略的,比如IQ Index的HFXJ;(3)采用100%对冲策略的,比如WisdomTree的DXJ;(4)采用动态对冲策略的,比如WisdomTree的DDJP。1、3两种策略的基金较为普遍和成熟,3、4则是新近出现,3是去年6月上市,4则是今年1月才上市。这篇笔记写作之前花了较多时间进行文献阅读,对这几种策略进行了比较,试图从更宏观角度来理解和把握这4种策略的关系。