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.”
But does FX provide a level of portfolio and market return diversification not offered by the local equity markets? If an investor had to decide to allocate to the EAFE FX1
embedded in the MSCI EAFE Index
as a standalone investment, let’s review the case.
• Over the history of the MSCI EAFE Index, EAFE FX has added 1.6% annually to the returns of the MSCI EAFE Index. This means the U.S. dollar declined by 1.6% per year over this period.
• This return stream had an annualized volatility
of 8.4% per year, a little more than half the volatility of EAFE equities (in local currencies).
• The correlation
of EAFE FX to the S&P 500
over the full 40-year period was fairly low—only 0.09. But note a very important correlation trend: This EAFE FX correlation to the S&P 500 has been rising consistently in recent periods. In the last three years, the correlation between EAFE FX and the S&P 500 was 0.64, so EAFE FX is not providing the same type of diversification as it did historically.2
Figure 1: MSCI EAFE Index: Return, Volatility and Correlation
More importantly, one has to wonder if the past gain in EAFE FX can be repeated. We know with hindsight that the U.S. dollar declined. But do we know the U.S. dollar will decline going forward? Theoretical models suggest there is no expected return to owning currency
. So why does one want to take on this FX risk embedded in foreign equity exposure unless one is a tactical U.S. dollar bear?
• The correlation to the S&P 500 for EAFE with FX and EAFE with no FX shows practically no differentials over the last 3-, 5-, 10- and 20-year periods. There is a slightly lower correlation to EAFE with FX over 40 years of data, but that does not appear to be a compelling case to add currency exposure on top of the local equity market return given the uptick in total volatility from adding FX and the unpredictability of future currency moves.
The Declining Diversification of Owning the Euro
Below is the same chart for the European FX3
correlation to the S&P 500, which also shows a consistent increase and less diversification from holding euros on top of owning the European equities.
• The European FX as a standalone asset class historically had 10% volatility consistently over most major periods—again, just about half the volatility of the local equity market.
• The long-term returns to the MSCI EMU Index
currencies were only 0.1% per year—this means the risk-return trade-off for European currencies as a standalone asset class showed relatively miniscule historical returns with large volatility (a bad combination).
• EMU FX over the long run had a correlation of 0.14 versus the S&P 500, but that has risen significantly to 0.68 over the last three- and five-year periods. This rising correlation means there is less diversification benefit to owning the euro.4
Figure 2: MSCI EMU Index: Return, Volatility and Correlation
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.
I believe it’s necessary to take a harder look at the diversification attained by adding in this FX risk. If investors evaluated FX as a pure standalone investment instead of a package product, I think they would rarely find themselves convinced of the reason to add in this exposure to their portfolios. There has been rising correlation to the S&P 500, low historical returns to FX, high historical volatility and a tactical environment that looks likely to favor the U.S. dollar.
For more of our research, see our market insight here
References currency exposure of MSCI EAFE Index.
WisdomTree, MSCI, 12/31/69–7/31/14. Applies to all bullet points.
References currency exposure of MSCI EMU Index.
Sources: WisdomTree, MSCI, 12/31/87–7/31/14. Applies to all bullet points.