Dan Petersen

And when those first came out, there was a lot going on in Japan to intentionally devalue the yen, spur exports. They titled it Albainomics back then. And it seemed like a pretty logical trade to want to hedge Japanese yen and go long the equities because of what they were doing to their currency. Unfortunately, if you look at assets in that space, most people relate to that trade. A lot of the assets flowed into hedged Japanese equity products a little after the fact. And if you were to look at performance of those assets that came in, they underperformed on hedged assets. And it was a bit of a traumatic trade for many. And in our conversations, for those that were around for that, we find that most people just do not want to do anything in terms of making a decision to have

Or to have not currency. And they just go with the default option. If you look at indices, all indices are US dollar based. So when you're benchmarking, you generally have the impact of currencies reflected in the benchmarks as well. So we're trying to deliver an option here that lets people understand that there is a neutral way to do this, to have some currency exposure, but not have as big of an impact as we've seen over the years with full currency exposure. So what we're doing is hedging half of the risk, which allows people to not have as much volatility that comes from currency, but also participate in foreign currency strength when it does happen.

And that allows investors to not have to decide, what do I do now? Do I tactically move towards hedging or not hedging? Am I chasing my tail? Well, when I look back at performance, I see what has done well. But if currencies mean revert, I might not want to do what has done well. And it gets into a very deep rabbit hole of decision making that is impacted by just a tremendous number of different possibilities, whether it be interest rates, geopolitical risks, and things of that nature. So we're trying to provide almost the most passive approach, which is market cap weighting and half of the currency exposure. Got it.

It's now on their market and I'm buying Toyota or whatever Japanese equity I want to buy. Toyota or whatever equity it is goes up 5%. Cool. I get my 5% return. But in the meantime, the yen also devalues versus the dollar 5%. So when I translate that back to U.S. dollars, I actually have a 0% return. It is, one for one going to reduce or increase my return. So it is significant. And if you look at this on an index level and you assume, okay, there's, Japanese companies in here, there's European companies in here. all the different developed nations and the various currencies that are involved. And if I look at that as a holistic approach from an index level, it is not uncommon to have 1,000 basis points or 10% of attribution in one year up or down.

That's kind of the widest part. currencies move throughout the year. So we'll see on average is about 600 basis points of additive returns or detracting returns. But again, it can blow out to as much as 1,000 basis points in either direction. So great if it helps me. But if I'm subtracting 10% from my return on equities, I don't know, if I'm planning for that. Am I having a strong opinion about that? And if I don't, I might want to reduce the exposure there because that's pretty significant.

Generally speaking, it's when you have even an expected inflation and stable growth that foreign currencies will strengthen relative to the dollar. So the dollar benefit, the U.S. dollar benefits from risk, right? There's a flight to quality trade that happens where everybody starts to go into the dollar for stability if we're in a market downturn or any type of recession. But there's also high growth scenarios like we've seen over the past several years where there's a U.S. dollar strength phenomenon that happens as well just because there's a lot of U.S. centric growth happening globally. So if you think about that, there's this phenomenon called the dollar smile, right?

So there's these two ends of the spectrum where the dollar strengthens and then there's that middle ground, which actually should happen more commonly where you have expected inflation and stable growth where foreign currencies can benefit. Unfortunately, especially for that left tail where we're in a recessionary environment or risk on environment, equities are moving down and there's a flight to quality with U.S. dollar. So if you have both equity and foreign currency exposure, you're kind of getting double the downside. And we saw that in 2022 when the international indices performed as poorly as U.S. indices, right? The S&P 500 was down around 16 percent. I don't remember the exact number. And if you were to look internationally at an MSCI EFI index or a FTSE developed markets index, it was also down about 15, 16 percent.

And if you look at the attribution of that, the equities were only down about 8 percent. So it would have been an OK diversifier to have part of my equities only down 8 percent. But because of the currency impact, it was down as much as U.S. markets. So especially in those risky environments where both equities and currencies are down, that's where any amount of hedging is going to be appreciated in the portfolio. if you're great at timing these things, go fully hedge, time it. Cool. And then get back into unhedged, when it's working for you. But these cycles play out short, medium and long term. So it's really difficult to play around with a portfolio and time it right.

And our approach is have some to benefit, but also lower the risk so that it's more in line with what people might generally expect. if currencies by and large long term are contributing, 30 percent of the return, I'd want to have a pretty strong opinion with something that that powerful 15 percent of the return. here's something where I can kind of say, OK, it'll help sometimes. It'll hurt sometimes. And I'm kind of OK with that level. And that's why the 50 percent number works pretty well.

So you have a little bit of different country exposure. Vanguard has a product that tracks also FTSE, but it includes Canada. So MSCI EFI does not include Canada, but FTSE, the version of FTSE that Vanguard uses with one of their products does include Canada. So there's all different ways to slice and dice, develop markets exposure. And then you can go out into the old world, category where you're now including emerging markets as well. So, you can look at these very different ways, even though they're market cap weighted. But generally speaking, if you were to look at correlation, very high with straight developed markets exposures. You're looking at 99 plus in terms of correlation over most time periods.

The U.S. is always priced a little higher. There's more demand for U.S. companies, it seems, in the open market. But to your point, there is a range. It's always discounted, but it's been, in the past we've seen, U.S. PE. If we look at the S&P 500, it might have been in the low 20s. And international might have been, 15, 16. So it's discounted, right? We're looking at maybe like, 75% or so in terms of the price earnings comparison there. But right now, if you were to look at, developed market indices, whether it be FTSE or MSCI, you're looking more about 17, maybe high 16s, and the U.S. is 27. So now it's really stretched, to your point, several standard deviations away from the average.

And I'd argue maybe even in the bottom 10th percentile. That's about how far away we are within that range of discounts. So the rubber band is definitely very stretched right now. And that paints a picture of opportunity, whether that be the U.S. comes down or the international catches back up. We don't know where we'll go. But when I look at a portfolio and you say, what's the opportunity for international? It's definitely a diversification potential. And there's evidence using price earnings to be able to point to, to say, why we're making this decision, maybe to start to increase international exposure to portfolio again.

And we are starting to actually see that pick up. That was a long conversation for many years in the working. But if you look at, Morningstar flow data in various categories, we do see far and large blend picking up a little bit in assets compared to what it's done historically. So there's definitely opportunity there. And we also see things like central banks are, already starting to cut rates. They were a little ahead of the U.S. in terms of the rate cutting cycle, which might point to, opportunity as well overseas, compared to the U.S., which is still a little restrictive. We don't know how fast the U.S. will be going forward in terms of cutting rates. Yeah.

I don't know, 36 months. And if you're not invested in market cap weighted U.S. indexes, specifically, the S&P 500 and the Nasdaq, you can't keep up. And so I understand their argument. But to me, and to your point, you don't know which is which, right? You don't know whether or not the U.S. is going to come back to earth a little bit, or if you're going to get this catch up from international equities. I tend to favor the first part of that, that, the U.S. probably could use a little bit of a cool off here and allow that kind of differential catch back up a little bit. But I think just as an asset allocator, you've got to continue to look at internationals

And even some emerging markets as a place to diversify some assets. But I don't know what your take is. But to me, it just seems as if asset allocation or, traditional asset allocation has been really tough for advisors over the last handful of years. And you're starting to see some massive concentrations in portfolios, not only to specific stocks, but, I'm seeing portfolios where people have 30% exposure to the mags ETF. they just want to buy the seven. And it's frustrating as somebody who helps assist in that process to see it because you know it's coming.

In excess of 20% annual returns in six of the past eight years, which is pretty wild, right? A lot of people have only been around for eight to 10 years, only know this. But if we look back historically, we have the tech bubble, right, where you had, it was similar, where you had a handful of, 20 plus percent years in the S&P 500. And then the prior period to that would be the late 70s, early 80s, where we had a strong run in U.S. domestic markets. In both of those prior periods, and it's not a large number of periods, it's only two periods that we can look at. Both of those prior periods, the international indices exhibited annual returns in excess of 20% for the following several years.

So it was a place to go that maybe had a little bit of a, like a tag-on performance from U.S. strength. One period, of course, the tech crash didn't end well for U.S., but the late 70s and early 80s, actually, U.S. continued to have decent strength. It wasn't 20 plus percent, year returns. You were better off diversifying internationally. But it's good to see that historically, this all doesn't end poorly, right? There is some kind of light at the end of the tunnel. It doesn't have to be that everything goes down and international goes down less. It could actually be that international does have strength going forward. And maybe that's a bolt-on effect from what's happened in the U.S.

And that kind of exists in short periods where reducing currency risk could actually increase your standard deviation. But it's actually very rare to find out in the developed world, especially at the index levels. At the index level, there is a slightly positive correlation, but it is a separate and distinct time series return because there are times where currencies correlate and times where currencies don't correlate. But by and large, when I reduce currency exposure in the portfolio, it takes away volatility. So we look at this as a way to pair with active in order to lower your volatility and maybe come closer to a benchmark exposure, but maintain your active exposure as well as a satellite or, to whatever extent you want to maintain active.

And definitely as a passive substitute in portfolios for international, just again, have maintaining your market cap weighted equity, not tinkering with your equity weighting. there are smart beta strategies and other ways to approach international to try to reduce volatility. But many times we find that sacrifice returns as well. So this is a way that you don't give up any equity exposure whatsoever, but you're able to reduce your volatility through currency reduction.