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.