BlackRock Has a Not-So-Secret Formula for Predicting the DollarBy
New ETFs use momentum, valuation, volatility to hedge FX risk
WisdomTree rolling out its own dynamically hedged funds
For U.S. investors tired of sweating the dollar’s trajectory, BlackRock Inc. says it has the solution: a formula that decides when to hedge the currency risk of international stocks.
The world’s largest money manager is applying the blueprint to a trio of new exchange-traded funds that aim to anticipate dollar strength by measuring four indicators: momentum, valuation, volatility and yield differential. By using trading strategies more commonly associated with hedge funds, BlackRock plans to lure investors seeking to protect the value of overseas returns from dollar gains, while preserving tailwinds from stronger foreign currencies.
Investors piled into currency-hedged ETFs over the past two years amid a 22 percent surge in the dollar fueled by the diverging central-bank policies of the U.S., Europe and Japan. Yet consensus on the greenback’s path is in short supply this year. Barclays Plc and Bank of America Corp. forecast the dollar to rally 13 percent versus the euro by year-end, while HSBC Holdings Plc calls for it to weaken 10 percent. That has BlackRock seeking to capitalize on dollar uncertainty as it looks to repeat last year’s unprecedented $47 billion of inflows into foreign-exchange hedged ETFs.
“You really have to ask, number one, do you agree philosophically with their way of predicting currencies?” said Linda Zhang, senior money manager at Windhaven Investment Management Inc. in Boston, which oversaw almost $13 billion via ETFs as of Sept. 30. “The success of these products will largely depend on how accurate they are in terms of forecasting currency directions. And that is a difficult job.”
Last year showed the challenges facing currency managers. Predicting dollar appreciation proved more art than science when a first quarter surge gave way to months of consolidation. That derailed the expectations of analysts and traders who, having prepared for the dollar to strengthen to parity versus the euro, were forced to backpedal. While 20 of 69 analysts surveyed by Bloomberg saw the euro falling to $1 or below by year-end on March 31, only two held that view by the end of September.
With the dollar’s rally slowing in recent months, fully hedged ETFs have begun to see withdrawals. Last month, about $1.3 billion exited the more than 90 U.S. ETFs that seek to hedge all of their investments’ currency exposure, and an additional $1 billion has left these funds this year.
That’s because the scope for further dollar-supportive policy divergence has waned, diminishing the immediate benefits of a currency hedge. Central banks in Europe and Japan are nearing the limits of their stimulus programs, while the Federal Reserve has finally increased rates from near zero, HSBC analysts led by David Bloom, the bank’s global head of foreign-exchange research, wrote in a report this month. As a result, investors are wondering whether a full hedge still makes sense.
“The whole point of designing this was to create a product for investors who don’t want to make that hedging decision themselves -- they don’t want that burden,” Ruth Weiss, the San Francisco-based head of U.S. product at BlackRock’s iShares unit, said by phone. “You’re really taking all that guess work out of currency hedging for them.”
BlackRock uses calculations of the dollar’s momentum, valuation, volatility and yield differential versus historical averages to generate four independent conclusions for each currency pair in the ETF: hedge or don’t hedge. Each signal contributes either 0 percent or 25 percent to the fund’s total protection.
The momentum measure will indicate a hedge when the dollar has returned more than the relevant foreign currency during the previous six months, while the valuation metric weighs recent spot prices versus the Organization for Economic Co-operation and Development’s purchasing-power-parity exchange rate, according to fund filings with the Securities and Exchange Commission. One-month volatility is compared to a six-month gauge of price swings, and two-year yields on U.S. and overseas rates determine yield differentials.
The hedge ratios are applied to underlying indexes that the ETFs seek to track using currency forwards, and are revised monthly.
“The more complex the calculation gets, the longer people will take to see how it works,” said Monish Shah, the New York-based head of ETF business at Mizuho Securities USA Inc. “Most of the smart shops are going to adopt a wait-and-see approach. They will see how the model performs as, at the end of the day, it’s a quantitative model that’s based on historical patterns or historical data.”
BlackRock’s three products cover the euro area, Japan and developed markets. The Europe-focused fund would have gained 5.1 percent over the past 10 years tracking its underlying index, according to back testing from MSCI Inc., which created the gauge. A similar fully hedged fund would have returned 4 percent, while an unhedged fund would have gained 2.3 percent, MSCI data show.
BlackRock’s dynamically hedged euro-area fund has a 0.5 percent expense ratio -- slightly higher than its similar unhedged product but lower than for an equivalent fully protected ETF.
Challengers to BlackRock have already surfaced. WisdomTree Investments Inc., which runs the world’s largest currency-hedged ETF, is rolling out its own dynamically hedged funds. The company has teamed up with Record Currency Management Ltd., a U.K.-based currency manager that oversees more than $50 billion, to oversee the hedging indicators.
Persistent foreign exchange swings will foster interest in products with a flexible hedge, said James Wood-Collins, Record’s chief executive officer.
The approach “draws investors’ attention to the risk that currency can bring to their portfolios,” he said.
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