The discussion of currency-hedged strategies has shaken some of the core beliefs of investors. Traditional investment vehicles that package equity risk plus a secondary currency risk on top of the equity risk have been referred to as the traditional “plain vanilla” exposure because they were the first to the market, and it is what investors have been using for so long.
We have been exploring the case for layering in foreign currency (“FX”) on top of foreign equity returns. One of the most common arguments I have heard for taking on FX risk in international equity portfolios in an unhedged fashion is that FX can be a portfolio “diversifier.”
On September 4, the European Central Bank (ECB) took further accommodation to support the economic growth environment in Europe. As a result, the euro collapsed about 1% immediately after the news, while European stocks rose on prospects for more monetary policy easing. This reaction mirrors what we saw in Japan in 2013, and it strengthens the case for taking the euro out of Europe.
If few U.S. investors would leverage up their S&P 500 exposure with a secondary bet on the U.S. dollar, why should it always make sense to layer on euro risk when buying European equities or yen risk when buying Japanese equities?
We’ve been writing about currency hedging for some time, and we continue to advocate that, if an investor isn’t sure of the future direction of an international currency—in this case the euro—the baseline exposure should not be in a 100% unhedged approach. We’ve seen strong interest in currency hedging within the broader eurozone region, but those looking at the performance of German equities in particular have not yet embraced the hedged concept. Given European Central Bank policy and the trend of the euro, we believe it could be time to think about currency hedging of both broad, eurozone-related equities and German equities.