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Structure Matters: Hedging South Korea

Dan Weiskopf
This column is part of a new collection of our “Structure Matters” series of interviews with leading ETF and index industry figures. They are conducted by Dan Weiskopf, a portfolio manager at New York-based Access ETF Solutions LLC.

This column is part of a new collection of our “Structure Matters” series of interviews with leading ETF and index industry figures. They are conducted by Dan Weiskopf, a portfolio manager at New York-based Access ETF Solutions LLC. In today’s piece, Weiskopf interviews Jeremy Schwartz, director of research at WisdomTree, about what factors investors should look to when they are addressing the currency question regarding South Korea.

Dan Weiskopf: What factors should investors be monitoring to know whether they want to be hedged on the South Korean won?

Jeremy Schwartz: Certainly the currency volatility is one important factor. You saw this where the Korean won was trading versus the dollar; it bottomed out in 2014 at around 1009. It was getting close to the 1,000 level and it started making the Koreans more uncomfortable.

They started talking about it more in the rhetoric, saying the strengthening won was hurting them. Now they’re at 1,143. You have seen almost an 11 percent depreciation just in the last 12 months. You’re seeing that currency start to weaken.

When I look at what the factors about hedging, the cost to hedge is certainly an important factor. That cost to hedge is based on interest-rate differentials, which are coming down as the Koreans are cutting interest rates.

Today their [similar] Fed fund type rate is at 1.25 percent, down from 1.5 percent after a recent cut. In the context of our potential rise in interest rates, I think the interest-rate differential versus the U.S. will just get wider and more interesting.

As we raise rates and as they lower rates, that cost can converge toward zero, which means investors could possibly get paid for the hedge over the next 12 to 18 months. Now that would be a big deal.

But the Koreans are not just worried about the dollar. They're increasingly focused on the won versus the yen. It used to be essentially 7 won to the yen, and now it's 11. That’s a 50 percent depreciation versus the yen, which makes Japan a lot more competitive. If the yen keeps depreciating, I would expect the Koreans to take more action to weaken their currency.

Weiskopf: You mention in a recent white paper that equities in South Korea are trading at 2009 levels. What factors have led to this discount, and what catalysts should we be looking to that might lead to a narrowing of this discount?

Schwartz: The valuation that we say is at 2009 levels is the price-to-sales ratio, which is at 0.6. There are very few countries trading at that low multiple. Even Russia is selling at a 0.8 price-to-sales ratio. I think the factor that is hurting South Korea is the profitability of its companies, which again is clearly helped by a weaker currency, given that their economy is so export-driven.

We wrote a piece recently that showed a chart that essentially compared the profitability of the consumer discretionary companies in South Korea versus Japan, and the relative profit differential there was dramatic.

When you even look at a price-to-earnings ratio, 10 to 11 times earnings for South Korea—knowing that the broad developed market index is 15 to 16 times earnings and the U.S. is at 17 to 18 times earnings—you see it's relatively on the lower price range of developed or emerging market. But even for the standard price-to-earnings ratio, which includes that lower profitability, you can see Korea is a relatively low-priced country.

With a weaker won, the profitability of the companies exporting would become more profitable, which itself would make the market cheaper and arguably provide more of a reason to narrow the valuation gap.

Weiskopf: Your index for the WisdomTree Korea Hedged Equity (DXKW) is roughly equally balanced at 25 percent between materials, technology, consumer and cyclical, and industrials. As a result, the index is underweight Samsung versus the MSCI index and technology overall, and a bit more exposed to midcaps and other indexes. Why is that? Was the index constructed with a broad slant toward exporters?

Schwartz: If you look at the broad MSCI indexes, Samsung definitely tends to get around 20 percent—sort of a very large outlier. We wanted to put more restrictions in our top holdings with a cap of 10 percent, and, similar to our Japanese hedged ETF [the WisdomTree Japan Hedged Equity (DXJ | B-66)], we're tilting the weight away from just local economy stocks.

We're underweight financials. We're underweight technology because we capped out our top holding at 10 percent. And it’s not as capped out in that broad market index. So we have some more diversification.

You don't have one stock driving the majority of returns that are less than the majority of returns. And then we also do tilt toward those companies uniquely positioned for a weaker won, but financials are underweight because there are no financials that are broad globally based or exporter-based.

Weiskopf: What sectors might we be looking toward for earnings growth in 2016?

Schwartz: Again, as an export-driven economy, one of the factors will be China. You could say if China's economy has a hard landing, that will not be good for South Korea. China recently reported a strong GDP number, so if they do manage through their situation well, it could be one positive support for the export companies.

Weiskopf: There’s a lot of debate about whether South Korea should be classified as a developed or emerging market as a classification. As head of research at WisdomTree, where do you stand on that question?

Schwartz: South Korea’s GDP and per-capita income are definitely very close to developed-market status. However, we tend to be more closely aligned with MSCI’s definition of emerging markets, because the won is not a broadly free-floating-type currency—one of the major characteristics of developed markets. It really comes down to some of these operational market-access questions.

Weiskopf: Dividend payouts in South Korea are starting to increase. Can you speak about this trend, and how this as a factor might be a predicative indicator?

Schwartz: Very importantly, look at their tail ratio. This is one of the reasons WisdomTree uses an earnings-related model to lead South Korea—it has one of the lowest tail ratios the world. It was just up 15 percent.

What's interesting is government basically started instituting a tax. You can get around the tax if you do more capital spending, or you pay your employees more or if you pay dividends. And you saw this in 40 percent of the assets in our index.

One way companies can lower their underlying taxes is to pay dividends. You get a tax credit essentially. That's going to encourage companies to pay dividends, and we think that's going to continue to be the case over the coming year.

When we do a broad earnings-weighted metric, you tend to have high levels of retained earnings. Return equity times essentially your retained earnings needs to be stable over time. The earnings tend to give you those higher levels of retained earnings.

Korea’s right now is at a 15 percent ratio. The broad MSCI is more than 30 percent. The U.S. is at 30, and it's at historical low levels just at 30. We think that ratios are likely to rise for a lot of reasons like that over the coming few years. You could see it at that broad number for emerging markets closer to 30, or even higher now that they're actually incentivizing.

Weiskopf: Thank you Jeremy. As a macro investor, I appreciate having the additional tools available to me that firms like yours provide. A global investment world deserves truly global solutions.

Dan Weiskopf is a portfolio manager at Access ETF Solutions LLC, whose third-party ETF strategies are offered through IPI Wealth Management, Inc. (IPI). IPI is an SEC-registered investment advisor, with its principal office located at 226 W. Eldorado St., Decatur, IL 62522, 217-425-6340. Access ETF Solutions LLC is not affiliated with IPI. Readers are advised to read the full transcript of the interview, including disclosures at http://accessetfsolutions.com, or contact Dan Weiskopf at 212 628-4882. At the time of the interview, two model portfolios of the interviewer’s firm separately held positions in the WisdomTree Japan Hedged Equities (DXJ | B-66) and the WisdomTree Europe Hedged Equities ETF (HEDJ | B-48) as well as other WisdomTree ETFs. Accounts managed by Access ETF Solutions also may be long WisdomTree (WETF) stock. The manager holds a position in WisdomTree stock as well as call options, but has no position in Samsung stock.

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