By Brian Manby, Investment Strategy Analyst at WisdomTree.

Brian Manby, Investment Strategy Analyst at WisdomTree.

Over the past few years, many investors have avoided developed international equity markets. Anemic growth, disappointing economic data and geopolitical uncertainty blunted sentiment for most of the decade.

Add Brexit, trade tensions with the US and an investable universe that’s structurally underweight the best-performing sector of most benchmarks (technology), and you see why some investors have been skeptical.

Reasons for optimism

We’ve recently noticed a reversal in sentiment toward developed equity markets, and attribute it to a few developments:

• Recent inflows into developed international ETFs, after dismal outflows to begin the year, suggest investors are starting to close underweights.
• Economic data may be showing signs of bottoming. Recent upticks in industrial production in Europe signal the outlook could be stabilizing.
• Confidence in the new leadership at the European Central Bank (ECB). President Christine Lagarde, who began her term last month, is a new personality in Brussels and is characterized as a pragmatic negotiator rather than a conventional technocrat.

One of our preferred ways to invest in developed international markets is the WisdomTree International Hedged Quality Dividend Growth Fund (IHDG US).

Performance that speaks for itself

While performance in most developed markets has lagged that of the US, the performance record for IHDG stands out.

Over the past one, three, five-year and since-inception periods, the Fund has comfortably outpaced the average return of funds in its Morningstar peer group, the Foreign Large Growth category.

It has also outperformed the return of the MSCI EAFE Index in both local currency and USD terms. To our mind, this highlights the benefits of our stock selection process as well as the impact that a currency-neutral approach can have on total returns in international investing.

Source: WisdomTree.

While IHDG has generated excess returns, it has also been remarkable for the consistency of its outperformance. Over the one-year and three-year periods, it was consistently a top performer and was in the top 1% of all funds in its category over the five-year and since-inception timeframes.

Source: WisdomTree.

Looking under the hood

Launched in 2014, the Fund combines two features that we have written about extensively: the quality factor and currency-hedging.

In our view, quality is especially important in today’s market environment. IHDG’s emphasis on quality is derived from return-on-equity and return-on-asset screens, which can add defensive characteristics to a portfolio. It also helps allocate to companies with the potential to grow their dividend payments, which requires both financial health and effective use of retained income.

The focus on quality has tended to tilt the Fund’s portfolio away from the financial sector, historically one of the largest weights in the MSCI EAFE Index, which has underperformed significantly since the global financial crisis.

Additionally, over the last five years, the most important “factor” for international returns was whether or not you were betting on the dollar to weaken.

You can see this clearly in the bar chart above (Figure 1), as the average Foreign Large Cap Growth manager outperformed the broad MSCI EAFE Index in US dollars by 1.7%, but these same managers still trailed the broad MSCI EAFE Index measured in local currency. Clearly, picking the right factor didn’t overcome the active manager decision to adopt currency risk.

Isn’t it ironic? The active stock manager says they are good stock pickers, not currency experts. We ask them then, why do they like to bet that the dollar will decline forever as they do in unhedged strategies. Why not focus on their core competency and just pick good stocks, while hedging their bet on the direction of the dollar?

WisdomTree believes the incremental currency risk is not worth the reward unless you have conviction that foreign currencies are set to appreciate.

The path forward

For the first time in a while, developed equity market sentiment is rebounding.

We maintain that a quality stock selection process coupled with a currency-neutral approach should be important parts of equity allocations.

Fortunately, IHDG provides both and has the potential to reward accordingly.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)