Despite half of the world’s stock market capitalization being outside the U.S., American investors maintain a “home country bias” with only 20% of the average investor’s equity exposure going to overseas markets, according to a recent Vanguard report. That said, the plethora of international-focused exchange-traded funds have opened up the world and made it easy to invest around the globe, and slowly but surely people are getting the message that it’s probably not wise to invest with one hand tied behind their back.
The question, then, is how to get that exposure? After all, investing in foreign stocks necessarily means making a currency bet, and that bet is an additional source of return—positive or negative—on its own. In other words, a gain in a foreign stock can turn into a loss for a U.S. investor if the foreign currency’s decline against the dollar exceeds the stock’s gain for the holding period. Similarly, a gain in the foreign currency relative to the dollar can turn an equity loss into an overall gain for a U.S. investor.
The way for U.S. owners of foreign stocks to avoid foreign currency exposure is by owning the stocks together with a currency hedge—typically a forward contract. A “currency forward” is a contract that locks in the exchange rate for the purchase or sale of a currency on a future date without requiring any up-front payment.
Investors in foreign stocks who hedge their currency exposure with currency forwards receive the return of the stock and the return of the local currency relative to the dollar (as do investors not using currency forwards), but then also receive the hedged currency return.
The following two formulae show the sources of return for unhedged and hedged investors:
Local market equity return + currency return = unhedged equity return.
Local market equity return + currency return – hedged currency return = hedged equity return.
So should an investor in foreign stocks hedge his or her exposure to foreign currency? Some strong evidence says yes.
High Volatility, Low Reward
First, foreign currency exposure imposes significant volatility on a portfolio. Although venerable value house Tweedy, Browne is not an ETF provider, it gives a detailed history of currency fluctuations in a paper defending the hedged approach. The firm initially ran a hedged global stock fund—the Tweedy, Browne Global Value fund (TBGVX)—before opening an unhedged version and an unhedged dividend-oriented global stock fund.
According to the Tweedy paper, currency fluctuations are more extreme than stock market fluctuations. During more than a half century, Tweedy counted that the S&P 500 had declined by greater than 20% four times. But currency relationships saw more frequent large moves—whether it was the U.S. dollar weighed against the pound, the dollar against the deutsche mark or the dollar against the euro. In the 1979-1984 period, for instance, the dollar value of British, French, German and Dutch currency declined by 45% to 58%, and in a 16-month period ending in early 2009, the British pound declined 35% against the dollar.
While it’s clear that unhedged investors are incurring more volatility, are they getting paid for it? According to a research paper from Applied Quantitative Research (AQR), an investment manager in Greenwich, Conn., they are not. The AQR paper argues that foreign currency exposure typically adds meaningful risk to international equity portfolios, without commensurate compensation.
“In other words,” AQR posits, “the amount of incidental currency risk found in a completely unhedged portfolio exceeds what could be justified by any reasonable excess return or correlation assumption.” AQR notes that unhedged international equity portfolios have 15% more volatility than hedged ones, and have suffered a maximum one-year drawdown that’s more than 30% greater.
In order to provide a diversification benefit by reducing the volatility of an otherwise diversified portfolio, AQR found that foreign currency exposure would have to be negatively correlated to the rest of the portfolio by -0.5. The problem is that foreign currencies have never exhibited that magnitude of negative correlation to a diversified, passively invested and capitalization-weighted portfolio. Moreover, such a high negative correlation is required because foreign currencies add virtually no additional returns. If an element of a portfolio doesn’t add returns, it can only be justified by reducing volatility with negative correlation—and foreign currency exposure has never accomplished that to the magnitude required.
Investors should note that AQR uses a modern portfolio theory approach, where risk is defined as volatility, so the firm’s argument is that the extra volatility of currency exposure isn’t rewarded. That doesn’t mean an investor can’t have an idiosyncratic view that he or she would like to express on currencies at a particular time. It also doesn’t mean an investor can’t simply benefit from foreign currency exposure if foreign currencies appreciate relative to the dollar for the time someone is invested. But it means that investors have never been compensated for the volatility foreign currency exposure has introduced to a portfolio in the past.
In other words, you can trade currencies if you have opinions about them. But you haven’t been able to introduce foreign currency exposure to a portfolio by owning international stocks in a passive, capitalization-weighted, unhedged fashion and get reasonably compensated for the volatility the currency has provided.
Problems Of Purchasing Power Parity
Even without the extreme character of currency moves, trends can last over long periods of time. That means investors can have exposure to a falling currency for longer than they might have planned. While the concept of purchasing power parity suggests that, over time, different currencies should achieve similar purchasing power, the theory doesn’t always compare well to reality—at least not over the short run. Currencies don’t snap back to equilibrium and equivalent purchasing power quickly, argue the theory’s critics, including ETF provider WisdomTree. That means investors who don’t have multiple decades may still be well served by hedging their currency exposure.
Moreover, currency hedging isn’t expensive for funds to accomplish. For example, WisdomTree notes that it is only expensive to hedge currencies that have much higher short-term interest rates than the U.S. So while it may be expensive to hedge exposure to the Brazilian real, it isn’t expensive to hedge to the pound, euro or yen. In some cases, investors actually get paid to hedge. In those instances, not hedging is a more expensive proposition.
Not only is hedging inexpensive, but it has been good to do it in the past when foreign stock markets have been poised to rise. According to WisdomTree, international stocks in the past have delivered the strongest returns when foreign currencies have generally weakened. So an unhedged investor has been at risk for having gains in foreign stocks negated by foreign currency drops.
In that vein, the current global macroeconomic landscape is one in which countries with heavy debt loads that are trying to stimulate growth are voluntarily printing money, lowering interest rates and eroding the value of their currencies. The problem is that weaker foreign currencies spell losses for unhedged U.S. investors in foreign equities. Even if foreign central bank monetary policy only produces volatility, investors aren’t being compensated for it, argues WisdomTree.
Hedged Options
Among the WisdomTree currency-hedged foreign-equity ETFs are two dedicated to the broad European market—the Europe Hedged Equity Fund (HEDJ) and Europe Hedged SmallCap Equity Fund (EUSC). Both funds offer exposure to European stocks while hedging exposure to the euro. The former gives investors exposure to multinational firms such as automaker Daimler, technology and industrial firm Siemens and pharmaceutical giant Sanofi. The latter provides exposure to clothing maker Hugo Boss, telecommunications provider Eutelsat, and financial services company Edenred. Both funds carry an expense ratio of 0.58%.
Another option for investors is Deutsche Asset Management’s 27 currency-hedged ETFs. Among the broad ones are the Deutsche X-trackers MSCI All World Ex US Hedged Equity ETF (DBAW) and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF).
With the former, an investor can get exposure to the entire world’s equity market, excluding the U.S., for an expense ratio of 0.40%.
With the latter, investors can gain access to the developed international markets in a hedged fashion for 0.35%. Among both funds’ largest holdings are food giant Nestle, pharmaceutical firm Novartis and energy producer British Petroleum. The All World ex US fund has emerging markets exposure, while the MSCI EAFE fund doesn’t.
Yet a third option from Deutsche is the Deutsche X-trackers MSCI Emerging Markets Hedged Equity ETF (DBEM) for investors who would like to limit their exposure to emerging markets currencies while they hold emerging markets stocks. The fund charges 0.65%.
Splitting The Difference
While there are good reasons for currency hedging investments in international stocks, some investors may still view exposure to foreign currency as another form of diversification. Even though foreign currencies haven’t provided it in the past, they may in the future. Other investors may have a strong view on currency valuations, and may want to express the view that, say, the dollar will decline while they are simultaneously getting international equity exposure.
For these investors, an unhedged fund is the appropriate choice. One such fund is the iShares MSCI ACWI ETF (ACWI). This fund will track the index that stands as a proxy for the world’s stock market for the price of 0.33%. Other choices include the iShares MSCI EAFE Index ETF (EFA), which will track the main developed international markets index for the same 0.33%, and the iShares MSCI Emerging Markets ETF (EEM), which tracks the main emerging markets index for 0.69%.
Finally, investors who are not sure whether the historical conditions that made hedging worthwhile in the past will persist may wish to hedge half their exposure to foreign equities. Over long periods, currency moves may cancel each other out, but the AQR research suggests that even some hedging would eliminate a meaningful amount of volatility.
John Coumarianos, a former Morningstar analyst, is a financial writer in Laguna Niguel, Calif.