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The Hedge of Least Regret

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The Hedge of Least Regret

As US equities continue their bull run, many investors are seeking ways to lower the risk of a downturn while maintaining, or even increasing, opportunities for growth. One obvious place to mine that opportunity is in the international equities markets. Reaching outside the US opens the door for investing in some of today’s most impressive global companies, including some of the world’s most famous—and most profitable—brands. It also offers a level of diversification that can help buoy a portfolio when the market shifts. But despite the fact that many companies with the largest market cap reside outside the US, international equities are generally underweighted and underutilized by US investors.

For many, that reluctance is rooted in the complexities and risk surrounding unpredictable currency fluctuations. It’s no wonder. A stronger US dollar can have a significant negative impact on non-US equity returns, and fluctuations in foreign currencies can exacerbate this effect. Currency hedging is often used to help manage this potential risk and combat the impact of a rising dollar, but it also has the potential to reduce returns if and when the dollar falls—even when the value of foreign stocks in the portfolio have increased. It’s a conundrum.

The good news is that, while currency hedging has its faults, it doesn’t have to be an all-or-nothing proposition. Even better, research has shown that there’s a true sweet spot to currency hedging that can help manage currency volatility and risk is a 50% currency hedge.1

The all-or-nothing challenge

Currency hedging can help manage the risks of large currency movements, but the common tactic is to swing one way or the other, going 100% hedged or 100% unhedged. The problem? The success of each approach hinges entirely on the direction of the US dollar. A 100% hedged portfolio historically delivered lower returns when the US dollar is weaker compared to international currencies. On the flip side, a 100% unhedged portfolio historically underperformed when the US dollar is stronger.1 Unfortunately, it’s notoriously difficult to predict currency movements. As a result, it can be nearly impossible to anticipate when a hedged or unhedged strategy might be the better option.

To further complicate things, every currency presents it’s own challenges. A fully hedged strategy may work very well in Europe and other developed international markets, but the strategy may backfire in others. This was exactly the case during the 10-year period ending in 2015 when hedging proved its worth in most European markets, but faltered in the Japanese markets. Why the variation? It’s all about the differences in correlation between two key factors: 1) the currency return and 2) the equity market return in local currency. Because this correlation was strongly negative for Japan, an unhedged currency exposure provided a natural hedge against fluctuations in the Japanese stock market. Hedging currency risk effectively reduced the natural hedge, but as the currency hedge percentage increased, volatility rose. In Europe and other countries where the correlation was strongly positive, currency exposure added to equity risk, and hedging this exposure reduced volatility.1

The 50% opportunity

Clearly, the all-or-nothing approach can create an undesirable level of risk in any market where the currency isn’t 100% predictable—which includes every market. (Anyone who doubts that statement need only look back at the impact of the Brexit vote on the British pound!). Research into the interaction between currencies and equity returns shows that a neutral 50% currency hedge on an international equity portfolio may potentially help reduce the risk of currency fluctuation. A 50% hedge may help buy-and-hold investors gain international equity exposure and reduce the effect of exchange rate fluctuations—all regardless of the direction of the US dollar or foreign currencies.

Due to the fact that the relationship between volatility and the amount of hedging is far from linear, a 50% currency hedge may capture a large percentage of the long-term risk reduction benefits of a fully hedged or unhedged portfolio at one point or another. Historical data shows that, over the long term, a 50% hedge would have significantly lowered volatility compared to a 100% unhedged portfolio.1

A 50% currency hedge may also help to provide a stabilizing effect on relative performance. The markets have demonstrated a frequent and often unpredictable rotation between when a 100% hedged or a 100% unhedged approach outperforms the other. A 50% hedge may offer a more prudent path to consistently realizing more balanced returns between these two extremes.

In today’s uncertain markets, a neutral 50% currency hedge may help ease the risk of investing in global markets, while also removing the need to constantly manage currencies that impact your diversified portfolio.

Reference:
1. Whitelaw, Robert, PhD. Hedge of least regret: The benefits of managing international equity currency risk with a 50% hedging strategy. April 2017.
Disclosure:
The information and opinions herein are for general information use only. The opinions reflect those of the writers but not necessarily those of New York Life Investment Management LLC (NYLIM). NYLIM does not guarantee their accuracy or completeness, nor does New York Life Investment Management LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice.
All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. 
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