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Dollar Sensitivity: The New Style And Size Debate

By Jeremy Schwartz When making investment decisions, many are familiar with making allocation decisions between large and small caps or between growth and value stocks. These decisions to over- or under-weight different segments of the market are what drive relative returns, and depending on your allocation mix, the returns can be quite different. Recently, as a result of the divergence in central bank policies, investors have also had to take views on currency risk, with clear winners and losers. Increasingly, we have seen investors shift away from currency risk in the developed international markets-specifically Europe and Japan-and focus just on the equities through currency-hedged indexes. But what about the currency impact on domestic equities? Currency Factor in U.S. Equities Currency moves are not just important to foreign markets. In the U.S., we have also seen U.S. dollar strength impact stocks that are exposed to sales in foreign markets. It is widely known that a significant percentage of the revenues of U.S. companies in the S&P 500 Index comes from abroad. If the U.S. dollar continues to strengthen, this is likely to provide continued headwind for the companies with meaningful revenue from and business exposure in foreign markets. By contrast, if the U.S. dollar reverses, these firms should benefit. WisdomTree designed two new U.S. equity factor Indexes to help position investors according to their view of the U.S. dollar’s direction. WisdomTree Strong Dollar U.S. Equity Index (WTUSSD) – includes only firms that derive more than 80% of their revenues from the United States. These companies tend to be less impacted by a strong-dollar environment-they aren’t focused on selling their goods and services abroad, and their import costs decrease with the dollar’s rising purchasing power. The Index also tilts weight more heavily toward stocks whose returns have a higher correlation to the returns of the U.S. dollar. WisdomTree Weak Dollar U.S. Equity Index (WTUSWD) – includes only firms that derive at least 40% of their revenues from exports. These firms tend to be more impacted by a strong-dollar environment, as they are focused on selling their goods and services abroad. Similarly, during a weak-dollar period, we’d expect these firms to become more competitive in selling their goods abroad. The Index also tilts weight to stocks whose returns are more negatively correlated (or have a lower correlation) to the returns of the U.S. dollar. Below we compare the since-inception performance of the WisdomTree Dollar Indexes, as well as popular size and style indexes, to get a sense of divergence between factors. Index Performance (click to enlarge) For definitions of indexes in the chart, visit our glossary . Dollar Indexes Divergence: we find the 3.98% divergence between WTUSSD and WTUSWD interesting, especially considering the short-term performance period. Despite that and the fact that analyzing just performance is not a robust statistical analysis, it seems there have been clear winners and losers, with WTUSSD coming out ahead. It is also interesting that the discrepancy is larger than the 2.92% difference between the S&P 500 Growth and S&P 500 Value, leading us to believe that the WisdomTree Dollar Indexes are offering differentiated exposures. Performance Differences between Size Indexes: have been the smallest (at 0.23%) of the indexes shown above. The difference is interesting to us because we often hear that small caps should be impacted less by a strengthening dollar because their revenues are typically more domestically focused. We estimate the weighted average revenue from outside the U.S. at 19% and 38% for the S&P Small Cap 600 and the S&P 500 indexes, respectively. Again, the period is short and there could be other factors driving the returns, but it is something we will continue to monitor. Can the Separation Continue? One of the most important macroeconomic forces impacting the markets have been currency changes motivated by diverging monetary policies. If you believe the U.S. dollar will continue to strengthen over the coming years, as is WisdomTree’s baseline view, this could provide the backdrop for continued divergence among U.S. equities. The degree or speed of the divergence is hard to predict, but we think it will be important to continue monitoring the performance differences for this new factor and look to provide commentary around any continued divergence. Important Risks Related to this Article Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”

What Lies Ahead For Dollar ETFs?

Although the Fed rate hike hearsay continues to dominate the headlines, investors haven’t really seen this speculation shift to huge gains for the U.S. dollar, at least not in the recent time frame. In fact, the greenback – as represented by the U.S. dollar Index – has lost its value in the last one month and five-day period (as of September 15, 2015). One of the reasons for this unexpected move was an extremely dour trading scene throughout August and the start of September. Maddening economic issues in China – a currency devaluation and a six-and-half-year low manufacturing data for August – took the global market in its grip, and crushed the global equities in the last one month. Yet the U.S. dollar has held firm in 2015 (so far), as many investors remain long-term bulls on the world’s reserve currency due to a recovering American economy. This was truer as the most developed and emerging nations are dragging their feet currently, leaving the U.S. as the lone star. The U.S. economy underwent an upward GDP revision for the second quarter of 2015, from 2.3% reported earlier to 3.7% upgraded later on strong domestic demand. If this was not enough, the unemployment rate dropped to 5.1% in August, the lowest since April 2008. This more-than-seven-year low unemployment rate should bolster the case for an imminent policy tightening. Additionally, average hourly wages rose 0.3% sequentially and 2.2% year over year. The average work week also nudged up to 34.6 from 34.5 in the prior and the year-earlier months. All these made September lift-off a heightened possibility that should have bolstered the greenback, but kept it range-bound due to global market rout. Can Greenback Gain Post Fed? Things are at a critical juncture at this moment. Two ETFs offering exposure to U.S. dollar (USD) against a basket of world currencies – PowerShares DB US Dollar Bullish Fund (NYSEARCA: UUP ) and WisdomTree Bloomberg U.S. Dollar Bullish Fund (NYSEARCA: USDU ) – are up 4.1% and 5.8% so far this year (as of September 15, 2015) but retreated about 1.3% and 0.2% in the last one month, respectively. While many may view the recent dip in the greenback as a setback, we believe that this fall led the U.S. dollar and the related ETFs toward the fair valuation. These dollar-related products surged from the latter part of last year due to the diverging monetary policies between the U.S. and other developed and some emerging markets. The U.S. wrapped up its QE measure late last year while Japan boosted its gigantic asset-buying program and the Euro zone initiated a QE launch in early 2015. This policy differential made the U.S. dollar a king among its peer currencies while other developed currencies started to lose out on economic stimuli. As a result, the U.S. dollar index surged over 13% in the last one year (as of September 14, 2015). Thus, a certain pull-back will now help the U.S. dollar to better prepare for a rally if the Fed hikes rates this week). And even if the Fed opts for a December lift-off or sometime in early 2016, the U.S. dollar should prevail in the coming days as inflows of ultra-cheap money in Europe, Japan and some emerging economies will continue to weaken their respective currencies against the greenback, which is still stronger. Which ETF is a Better Bet? Given this, investors could definitely play the U.S. dollar by considering either UUP or USDU. UUP looks to track the U.S. dollar against a basket of six world currencies – the euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.10%), Swedish krona (4.20%) and Swiss franc (3.60%). USDU tracks the U.S. dollar against a basket of 10 developed and emerging market currencies. It allocates higher to the Euro zone currency at 32.5%, closely followed by Japanese yen (19.25%) and Canadian dollar (11.21%). Other currencies like Mexican peso, British pound, Australian dollar, Swiss franc, South Korean won, Chinese yuan and Brazilian real receive single-digit allocation each in the fund’s basket. Since, UUP is mostly exposed to the developed economies’ currencies; things are less likely to improve post Fed tightening. On the other hand, USDU gives exposure to a broader basket consisting developed and emerging currencies. Notably, most of the emerging market currencies are tumbling presently and are expected to fall out of favor post-Fed tightening. This should give USDU a scope for outperformance over UUP. Bottom Line Having said this, we would like to note that any resumption in the greenback rally should not be as great as it was late last year. This is because the market has mostly priced in the favorable outcome of the impending Fed lift-off and protracted easing in other developed nations like the Euro zone and Japan and their effects on the exchange rate. Original Post

China Funds And Black Monday

By Jake Moeller Lipper’s Jake Moeller examines the performance of China-themed funds during Black Monday week. Most investors will have been familiar with the compelling thematic stories about China for many years: population, infrastructure growth, urbanization, etc. Until 2011 all the China funds available in the market were equity funds. Today, there are nearly 100 UCITs funds (and considerably more share classes) with a China focus available in Europe. They cover not only equities; funds can be found specializing in emerging-market bond, mixed-asset, currency, and money market sector classifications. If we accept that mutual fund production reflects investor sentiment, we can illustrate the successful pervasion of the China story. In 2015 up to June we have seen 13 new major China fund launches in Europe (it will be interesting to see how many funds are launched in the second half of the year!). Indeed, nearly 50% of all the China-themed UCITs vehicles have been launched since 2010, with total assets under management for all of these funds increasing from €19 billion in 2010 to some €28 billion today-an increase of 47%. But as a whole, these figures represent a very small proportion of the overall UCITs market. (click to enlarge) Source: Lipper for Investment Management The variation of returns among China-themed funds during the Black Monday event was considerable and almost exclusively negative-only two funds returned a positive figure for the seven-day period ending 27 August 2015 ( Prescient China Conservative E [Hedged] USD , up 1.62%, and Amundi Eureka Cina 2015 , up 0.29%). Casualties at the other end saw losses over the same period of up to 18.2%. Some big name losers over the period included AllianzGI’s China A-Shares , which fell 13.8%; BNP Paribas Investment Partners’ Flexi I CSI 300 Index , which returned minus 15.5%; and KBC Horizon China , returning minus 17.3%. The overall average return during this seven-day period was minus 5%. It is an unusual practice and possibly unwise to spend too much time examining such short-term performance-especially in collective investment vehicles, but the overall volatility of some of these examples was breathtaking in isolation. Let’s not forget, though, that over that same short period the Investment Association U.K. All Companies sector, for example, also returned minus 5%-a figure comparable to the average return of the China fund. Similarly, the IA North America Sector returned -5.6% over the same period. Consider also some longer-term performance. Taking the one-year period to 27 August, there were some fairly impressive returns even with the Black Monday correction. KBC Horizon China , so maligned in our seven-day analysis, returned 57% over this period; Allianz China A-Shares (USD) , 69%; and the average of all the funds was a fairly robust 10%.