Don t Let Currency Risk Weaken the Strength of Germany s Equity Market

Transcription

1 GERMANY EQUITY UCITS ETF GBP HEDGED DXGP Don t Let Currency Risk Weaken the Strength of Germany s Equity Market Germany is Europe s engine of growth. As the policy picture has shifted and the European Central Bank (ECB) executes quantitative easing (QE) in an attempt primarily to avoid the risk of deflation, we believe that German equities particularly those that thrive by exporting could be in a position of strength. Let s face it a weaker euro makes what they re selling less expensive. QE could encourage the euro to weaken. FIGURE 1: THE EURO HAS BEEN WEAKENING OVER THE PAST YEAR (31/03/2014 TO 31/03/2015) 5% 0% Cumulative Return -5% -10% -15% -12.4% -12.9% -20% -25% Euro vs. Pound Euro vs. Dollar Euro Effective Exchange Rate -22.1% -30% Mar-14 Apr-14 Apr-14 May-14 May-14 Jun-14 Jun-14 Jul-14 Jul-14 Aug-14 Aug-14 Oct-14 Oct-14 Nov-14 Nov-14 Dec-14 Dec-14 Jan-15 Jan-15 Feb-15 Feb-15 Source: Bloomberg. The euro effective exchange rate is calculated by the Bank of England and is in effect the performance of the euro versus a tradeweighted basket of currencies. FOR PROFESSIONAL CLIENTS AND SOPHISTICATED INVESTORS ONLY. 1

2 GERMANY: A NATION OF EXPORTERS HELPED BY WEAKENING CURRENCY Over 50% of Germany s gross domestic product (GDP) comes from exports of goods and services. 1 Additionally, the weighted average revenues of German equities from outside of the Eurozone was 61% as of December 31, We think of this as a nation of companies with significant potential to perform in the environment of currency depreciation that we alluded to in Figure 1. BEST TIMES TO OWN GERMAN EQUITIES? WHEN CURRENCY WAS DEPRECIATING! But, before focusing solely on the more recent past, we were interested to complete a longer historical analysis of German equity performance. Going back approximately forty-five years, we examined whether German equities tended to perform better during periods of a weakening German currency (Germany adopted the euro on 01/01/99). FIGURE 2: GERMAN EQUITIES (IN LOCAL CURRENCY) DELIVERED STRONGER RETURNS WHEN THE GERMAN CURRENCY WAS WEAKENING 18% 16% 16.08% Average Annual Returns 14% 12% 10% 8% 6% 4% 3.98% 7.55% 2% 0% Down Currency Trend Up Currency Trend All Periods Source: MSCI, for period 31/12/1969 to 31/03/2015. Universe of German equities defined by the MSCI Germany Index. Down Currency Trends defined by periods where the German currency was weakening relative to GBP. Up Currency Trends defined by periods where the German currency was strengthening relative to GBP. To note, the German currency shifted from the Deutsch mark to the euro on 01/01/99. The German currency is used to refer to periods either prior to, or including the Deutsch mark. The MSCI Germany Local Currency Index also refers to periods either prior to, or including data prior to 01/01/99. + Significant Outperformance as German Currency Weakens: The average annual returns of the MSCI Germany Local Currency Index were over 16% when the German currency was weakening, but these average annual returns dropped to below 4% when the German currency was strengthening. Given that German equities returned around 7.6% p.a. over the full period of approximately 45 years, the currency trend had a significant impact. If history is any guide, there could be reason to believe that a weaker euro could lead to strength in German equities. 1 Sources: WisdomTree, Global Financial Data, as of 31/12/ Sources: WisdomTree, Factset. 2

3 HOW HAS THE ECB S QE PROGRAM MANIFESTED IN GERMAN EQUITY PERFORMANCE? While far from a certainty in 2014, on January 22, 2015 ECB President Mario Draghi announced a QE program. As a result: 1. Equity markets rallied both across the broad Eurozone as well as in Germany specifically. 2. As we saw in Figure 1, the euro weakened, creating a headwind for any unhedged investors looking to participate in Germany s equity rally. Bottom line: by being exposed to the euro (as opposed to GBP-hedged) prohibited fully capturing the strength of Germany s equities to the tune of about 15% as we can see in Figure 3. FIGURE 3: ONE YEAR TIME FRAME SHOWCASES THE IMPACT OF ANTICIPATION/IMPLEMENTATION OF ECB S QE PROGRAM (31/03/2014 TO 31/03/2015) AVERAGE ANNUAL RETURNS AS OF MARCH 31, 2015 YTD 1-Year Since WT Index Inception (01/05/2013) WisdomTree Germany GBP-Hedged Equity Index 20.4% 24.5% 24.2% MSCI Germany Index (in GBP) 13.7% 9.4% 13.9% EUR to GBP Exchange Rate -6.7% -12.4% -7.9% 30% 25% 24.5% 20% 15% Cumulative Return 10% 5% 0% -5% 9.4% -10% -15% -20% WT Germany Hedged (GBP) MSCI Germany (in GBP) EUR to GBP Exchange Rate -12.4% Mar-14 Apr-14 Apr-14 May-14 May-14 Jun-14 Jun-14 Jul-14 Jul-14 Aug-14 Aug-14 Oct-14 Oct-14 Nov-14 Nov-14 Dec-14 Dec-14 Jan-15 Jan-15 Feb-15 Feb-15 Sources: Bloomberg, MSCI, Standard & Poor s. Period shown is latest one year ended 31/03/

4 DON T MISS GERMANY S STRONG RISK/RETURN TRADEOFF As mentioned earlier, Germany was really the European engine of growth, but a critical question remains as to how that translates into risk-adjusted returns. We decided to compare the Sharpe ratios of the MSCI Germany Index in EUR to that of the MSCI Germany Index in GBP. FIGURE 4: REMAINING EXPOSED TO THE EURO LIMITED THE RISK/RETURN ADVANTAGE OF GERMAN EQUITIES 1.8% 1.6% 1.4% MSCI Germany (in EUR) MSCI Germany (in GBP) MSCI EMU (in EUR) 1.2% Sharpe Ratio 1% 0.8% 0.6% 0.4% % % 3-Year 5-Year 10-Year Sources: MSCI, Zephyr StyleADVISOR. Data from 31/03/1995 to 31/03/ Higher Sharpe Ratios than Eurozone Equities: We can see that the MSCI Germany Index had higher Sharpe ratios than the MSCI EMU Index over 3, 5, and 10-Year periods ending March 31, However, this benefit in risk-adjusted returns was completely lost by being exposed to the euro, as can be seen through the Sharpe ratios of the MSCI Germany Index in GBP. If an investor had purchased the MSCI Germany Index and hedged to GBP, they would have achieved a Sharpe ratio closer to that of the MSCI Germany Index in EUR (which was approx. 70% higher over the last 5 years). Our initial conclusion is that by not hedging currency exposure with German equities may be an unattractive risk/return tradeoff, and we explore the reason why within Figure 5. CURRENCY ADDING MORE RISK IN RECENT PERIODS In Figure 4, the difference in Sharpe ratio is most pronounced over the 3-Year and 5-Year time frames. The reason for this is the higher positive correlation between the EUR-GBP exchange rate and German equities during these periods especially the 5-Year. It s also interesting to note that while the movement of EUR versus GBP hasn t always been a positive contributor to returns, it has always been a positive contributor to risk thus remaining unhedged reduced the Sharpe. 4

5 FIGURE 5: CURRENCY ADDS TO RISK OF GERMAN EQUITIES German Equities (in GBP) Avg. Annual Returns German Equities (in EUR) Currency Return (EUR/GBP) Volatility of German Equities (in GBP) Volatility of German Equities (in EUR) Incremental Volatility Due to Currency Exposure Correlation of German Equities & Currency return Since euro adoption 3 5.2% 5.0% 0.2% 23.3% 21.7% 1.6% Year 14.1% 19.6% -4.6% 14.3% 12.5% 1.8% Year 9.2% 13.9% -4.1% 18.7% 16.3% 2.4% Year 10.2% 9.7% 0.5% 21.4% 18.7% 2.8% Year 3.7% 2.4% 1.3% 23.2% 21.4% 1.8% 0.02 Sources: MSCI, Bloomberg. Data from 31/12/1969 to 31/03/ Hedging German equities resulted in lower risk: In every time period shown in Figure 5, overall risk (as shown by the positive incremental volatility added by currency) increased when German equities was left unhedged. + Increasing Correlations Increasing Currency Risk: Over all the periods shown, there was positive correlation between currency returns and equity returns. There was higher correlation over the 3-Year, 5-Year and 10-Year periods, meaning that extra risk was incurred by investing in German equities without hedging. 3 To note, the German currency shifted from the Deutsche mark to the euro on 01/01/99. MSCI Germany Net Total Return index is used as proxy for German equities. German equities (in GBP) is the return, in GBP, of an unhedged investment in German equities. Currency returns are measured as the change in the EUR-GBP exchange rate where a negative return means EUR weakened relative to GBP, and a positive return means EUR strengthened relative to GBP. Correlation and volatility calculations are based on monthly return series. 5

6 INTRODUCING THE WISDOMTREE GERMANY GBP HEDGED EQUITY INDEX The WisdomTree Germany GBP Hedged Equity Index is designed to focus on a pure exposure to German equities while hedging the euro currency into British pounds. Additionally, it requires that each constituent derive less than 80% of revenue from within Germany, thereby tilting toward exporters. The full methodology is described within Figure 5. FIGURE 6: CONSTRUCTION OF THE WISDOMTREE GERMANY GBP HEDGED EQUITY INDEX Selection Rules Eligible Universes Market Capitalization 4 Liquidity Requirements Selection Methodology Component companies must list their shares in Germany, be incorporated in Germany and traded in euros. $1 billion (in U.S. dollars) 1) Average daily dollar volume of at least $100,000 for three months preceding the screening date. 2) Traded at least 250,000 shares per month for each of the six months preceding the screening date. 3) A further volume screen requires that a calculated volume factor (average daily dollar volume for three months preceding the screening date/weight of security in Index) shall be greater than $200 million. Companies must have less than 80% of their revenue come from Germany. Companies must also have paid at least $5 million (in U.S. dollars) in cash dividends on shares of their common stock in the annual cycle prior to the annual reconstitution. Weighting Rules Weighting Capping Rules Liquidity Adjustment Factor Each company's weight is proportional to its cash dividend per share paid over the annual cycle prior to the index screening date multiplied by its shares outstanding, or Dividend Stream 5, relative to all other Index constituents. Dividends are measured in terms of U.S. dollars. Exposure to any sector is capped at 25% as of the annual Index Screening Date. Between annual Index Screening Dates, sector weights may fluctuate above 25% due to market movement. If a security has a calculated volume factor less than $400 million, its weight will be reduced proportionally by a liquidity factor that equals the original calculated volume factor/$400 million. Implementation of this adjustment may cause an increase in constituent weights above other specified caps. Currency Hedge Mechanics of the Currency Hedge 6 Local Market Germany Equity Return + euro Return - Hedged euro Return = Hedged Equity Return. The currency hedging methodology consists of entering into a one-month forward currency contract in order to hedge the underlying foreign currency exposure between GBP and EUR. Source: WisdomTree TILTING TOWARD EXPORTERS STILL PROVIDES BROAD EXPOSURE TO THE GERMAN EQUITY MARKET One of the most interesting considerations concerns how the WisdomTree Germany GBP Hedged Equity Index compares to the MSCI Germany market capitalization-weighted benchmark in terms of sector exposures. Since greater than 98% of the weight of the MSCI Germany Index 7 was in firms that paid at least one dividend during the year prior to April 17, 2015, the true question is not about dividends versus market capitalization, but rather exporters versus domestically oriented firms. 4 Market Cap = share price x number of shares outstanding. Firms with the highest values receive the highest weights in approaches designed to weight firms by market cap. 5 Refers to the regular dividends per share multiplied by the number of shares outstanding. 6 Currency Hedging = strategies designed to mitigate the impact of currency performance on investment returns 7 Source: Bloomberg. 6

7 FIGURE 7: SECTOR BETS RESULTING FROM THE EXPORT TILT WT Germany Equity MSCI Germany Difference Consumer Discretionary 22.9% 22.2% 0.6% Consumer Staples 2.8% 3.8% -1.0% Energy 0.0% 0.0% 0.0% Financials 17.7% 17.7% 0.0% Health Care 12.2% 15.1% -2.9% Industrials 15.4% 11.9% 3.5% Information Technology 5.8% 6.9% -1.2% Materials 12.0% 14.0% -1.9% Telecommunication Services 6.5% 5.0% 1.5% Utilities 4.7% 3.4% 1.3% Source: Bloomberg, with data as of 31/03/2015. WISDOMTREE GERMANY EQUITY UCITS ETF GBP HEDGED AT A GLANCE: London Stock Exchange Code: DXGP BBG Code: DXGP LN Reuters Code: DXGP.L ISIN: IE00BVXBGY20 Listing Currency: GBx Fund Base Currency: GBP Financial Year End: 31 December TER: 0.35% Underlying Index: WisdomTree Germany GBP-Hedged Equity Index 7

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