Wesley Gray, the Alpha Architect, joined me recently in co-hosting a podcast with the Wharton School’s Nikolai Roussanov, one of world’s top academics on the topic of currencies. 

Roussanov’s academic work has focused on the carry trade—a currency factor he sees as explanatory in major currency group movements. The carry trade represents the tendency for higher interest rate currencies to outperform lower interest rate currencies, on average, over time. 

Roussanov and I debated the strategic rationale for currency hedging broadly. WisdomTree has been a rather passionate advocate for the view that investors tend to take on unnecessary risk when they invest abroad—one need not utilize double-decker strategies that package currency returns on top of equities. More simply, investors can buy single-decker strategies that have an expressed goal of delivering returns of equity markets only, mitigating risks from a secondary and distracting bet on currencies. 

Roussanov says currencies like the yen can offer diversification. I think the yen is an outlier when it comes to its strong negative correlations to equities. But when I pressed Roussanov if he believed investors should “always be betting long on the euro always going up” as required by unhedged double-decker strategies, he said that investors should not be doing that either. So what’s an investor to do?

Roussanov is a fan of “smart hedging” strategies that time foreign exchange (FX) hedges based on factors that historically have been rewarded and studied in the academic literature. 

FX Factors to Adjust Hedge Ratios

What are currency factors? Academics like Roussanov have focused on interest rate differentials—the carry factor. But there is also work on a value factor within FX and price momentum.

WisdomTree created smart hedging indexes that combine these three currency factors into a dynamic hedging family that raises and lowers hedge ratios once per month on these three currency factors. Value and carry are two relatively slow-moving signals and normally will not change that frequently.