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Looking Deeper Into Currency Hedging

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Regrets.

Most investors have had a few, and this year’s currency volatility has been another reminder of how unexpected movements in the dollar – and the investor reactions this may trigger – can impact portfolios.

Coming into 2018, there was a view that the dollar was likely to continue to weaken. A January 4th Reuters story pointed out that the dollar had just recorded its worst performance in 14 years in 2017, falling around 10%. The author noted experts expected that performance to improve in 2018, but at least at the start of the year, the “path of least resistance is down.”1

As it so happens, the dollar was up 3.53% against a basket of global currencies through September 20th, as measured by The Wall Street Journal Dollar Index.2 So much for predictions. For unhedged US investors, the strength in the dollar has had a negative impact on unhedged international portfolios. And, according to a Bloomberg story, fewer US investors hold currency hedged investments. Looking at ETFs, Bloomberg wrote that these funds had seen substantial outflows over the previous nine months, catching investors on the wrong foot as the dollar rallied during the year.3

That kind of reflexive reaction to short-term market moves has not usually been good for long-term returns. Over a three-year period, the WSJ Index has essentially made a round trip, starting at $88.76 on September 26, 2015 and ending at $89.01 on September 20th of this year. In between, it made stops at $93.50 and $82.97, among other waypoints. Any one of these could have resulted in an unhedged investor feeling the need to bail out. 2

Related: Market Balance: Currency Contagion, Trade Rhetoric, and Rate Hikes

Market data is what it is, and the advice of most investing experts is to ignore short-term volatility. Still, it’s human nature to react to changing conditions, particularly when financial assets are involved. In recent years, academics and others have recognized that to optimize outcomes you have to take into account how individuals behave in the real world. This is reflected in the growing influence of disciplines like behavioral economics.

One way to address this real-world behavior is by putting in place a 50% hedge on international investments, what we call the “hedge of least regret.” This can provide a cushion against dramatic dollar moves, up or down and, by softening the potential blow of unexpected currency volatility, help investors stay committed to a long-term investment program. It addresses both an objective need – hedging the impact of currency fluctuations – and, indirectly, investor behavior.

There’s another potential benefit, too, as we approach year-end: rebalancing an international portfolio to take advantage of potential tax losses in an unhedged or 100% hedged holdings while moving to a 50% hedged position.

As with currencies, we have seen the landscape shift in terms of the relative performance of US equity markets versus their global counterparts. The US stock market is currently outperforming other developed markets and has for much of the past decade. But that’s not always the case. A look at the returns of the S&P 500 versus MSCI EAFE (developed markets outside the US) shows periods of significant out-performance for non-US equities. Like most markets (and currencies), returns tend to be cyclical and subject to mean reversion.4 With this in mind, it’s hard not to conclude that International equities have a role to play in a diversified portfolio, and that a 50% currency hedge is a good way to get that exposure.

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