The latest weakness in the U.S. dollar has a number of investors re-examining the case for currency hedging their foreign equity portfolios. Many unhedged investors express thoughts like these: “See, there is a benefit to adding currency risk in my portfolio” and “This currency risk is all going to wash out in the long run, so why should I bother hedging, especially since I am likely to get the timing wrong to switch to a currency-hedged strategy?”
The important philosophical portfolio question investors must determine is this: Is there really a long-run benefit to portfolios from betting that currencies such as the euro, yen and pound will always appreciate in value versus the U.S. dollar?
The phrase “betting on currencies” is important to re-emphasize. There is no model that says the euro, yen and pound will always and forever appreciate in value versus the U.S. dollar. These currency exposures in unhedged strategies are thus always implementing a tactical bullish call on the euro, yen and pound versus the U.S. dollar.
In 2016 and the last 12 months, the euro and yen have appreciated from their lows. My question to unhedged investors is this: Why is your call for the euro and yen to continue appreciating from here? If you cannot make a strong case to be bullish the euro or the yen, you should re-examine why you always layer it on top of your equity exposure.
International Equity Volatility (12/31/1969—3/31/2016)
For definitions of terms in the chart visit our glossary.
I believe the long-run, strategic portfolio framework with the most sound underpinnings for international allocations incorporates one of two mindsets:
1) Strategically hedging currencies in the developed world as a baseline allocation all the time. This strategy, for broad baskets of international equities, can lower the volatility profile of international investing and means an investor does not have to worry about fluctuations in exchange rates.
Volatility Reduction: Over the last 47 years, currency has added 260 basis points (bps) to the volatility of stocks in the MSCI EAFE Index, despite having nearly zero correlation to those stocks.1 The evidence shows that, far from being an actual diversifier to a portfolio, foreign currency exposure is nothing more than a bet on foreign currencies appreciating in value. Sometimes the bet pays off, sometimes not.
If an investor wants to eliminate the need to make any calls or bets on currency directions, strategically hedging currency risk all the time is the most natural approach to achieving this goal, in my opinion.
Note, I believe most investors still think of this backwards, claiming the decision to “currency hedge” is the “active bet” they must make. But remember, currency hedging just seeks to neutralize exposure so that a portfolio doesn’t stand to benefit when the euro rises or doesn’t get hurt when the euro falls.
2) Dynamically Hedged currency exposure to adapt unhedged positions when hedging looks less attractive. Of course, there are times when foreign currencies will appreciate in value. But can you time those adaptive hedging moves yourself? Research we have conducted with Record Currency Management shows that it’s possible to add value over passive hedging (or unhedging) all the time.
Over the last 28 years, determining when to currency hedge using a three-factor model of interest rate differentials, momentum and currency valuations has added more than 140 bps annually to the returns of a broad international hedged-equity strategy while maintaining the vast majority of the volatility reduction of strategic passive hedging.2 This research led us to offer a family of dynamic currency-hedged Indexes that represent this exposure for broad international allocations, European allocations and Japanese allocations.
Unhedged MSCI EAFE Index with Passive Hedged and Signal Overlay (12/31/1988—3/31/2016—USD Based)
Most investors remain unhedged for their broad-based allocations to the foreign large-cap asset class. To me, this is the least sensible and defensible strategy over the long run. We know currency adds to an investor’s risk profile, and we believe there should be no “expected return” from these currencies (the “uncompensated risk” of currency).
The case for currency hedging remains as strong today as ever. This case mostly relies on being able to achieve a potentially lower risk profile when investing internationally.
The case is enhanced by the fact that the European and Japanese central banks have instituted negative interest rates, while the U.S. central bank is on a gradual glide path to raising interest rates. Far from being a cost to hedge the euro and yen, an investor is increasingly being paid interest rate differentials between the U.S. and the foreign central banks. The amount an investor is being paid to hedge using one-month forward contracts is approaching 75 bps in the euro area and almost 70 bps in Japan.3
On a Tactical Basis, Hedging Is Still Attractive
Interest rate differentials are perhaps the most powerful motivating force for long-run capital flows. The U.S. has among the highest interest rates in the developed world.
In Japan, not only is there a negative short-term yield, the 10-year government bond has a negative yield. These low yields increasingly encourage Japanese corporations, pension funds and citizens to look for opportunities to earn higher yields around the globe. The U.S. is likely going to be a recipient of these flows for an extended period.
While I remain tactically bullish on the dollar based on the longer-term trend in interest rates, it’s not necessary to be a U.S. dollar bull to adopt currency-hedged strategies. An investor just needs to accept the proposition that currency adds to the risk profile of international investments for no expected long-term benefit.
I believe that, as investors come to realize how much uncompensated risk they may be taking and that foreign equities could continue to look attractively priced compared to U.S. equities, investors may continue to shift portfolios toward either strategic or dynamic currency-hedged international strategies.
1Sources: WisdomTree, Bloomberg, as of 3/31/16.
2Sources: WisdomTree, Record Currency Management, as of 3/31/16.
3Sources: WisdomTree, Bloomberg, as of 3/31/16.