A recent white paper written by Catherine LeGraw of investment management firm GMO makes the case that most U.S. foreign equity investors should not use currency hedges. The topic of currency hedging is very popular right now given the strong dollar and recent underperformance of U.S. equity markets leading investors to invest in foreign stocks. That said, you would be well served to think twice about what you are really accomplishing by hedging in an increasingly global world, or if you are really hedging at all.
The problem with currency hedging in a global world
As LeGraw points out, the problem with currency hedging in today’s global world is that currency hedging only hedges your exposure to a small extent and also introduces additional risks. “In the age of globalization, most companies have multi-currency costs and revenues; shorting the local currency on top of the equity investment does not hedge an exposure, but rather adds new risks to the investment. Therefore, as a rule we do not hedge currency for equity investments, but there are exceptions. For example, if we owned a portfolio of domestically-oriented stocks with most costs and revenues in a local currency, we may decide to hedge the currency exposure.”
Four facts to keep in mind about currency hedging
In her paper, LeGraw points out that several of the traditionally accepted “facts” about currency hedging are really more like myths. For example, while currency hedging may decrease volatility over short investment horizons for USD investors, it clearly does not reduce volatility over longer horizons.
Second, it is clear that the volatility reduction one can get from setting up currency hedges has declined over time as firms are becoming increasingly more global.
Third, LeGraw highlights that even if currency hedging does decrease the short-term volatility of international equity holdings, it will not decrease the volatility of a global equity portfolio because hedged equities are increasingly more correlated with U.S. equities than unhedged equities.
Fourth, and an oft-overlooked consideration, is that currency hedging inevitably introduces leverage, which often ends up producing greater tail risk.
See full white paper below.