Adding Risk in a Zero-Sum Game: A Bad Idea

Many investors do not hedge currency in their foreign equity mandates. Their main rationales include a desire to conform to the status quo, a discomfort with hedging or belief in currencies’ diversifying effect.

Investors should think twice if they are strongly embracing any of those three approaches.

Let’s start with foreign exchange “diversification” during the COVID-19 crash, when the dollar surged during March 2020’s fear (figure 1). It’s like the old joke about “de-worsification”—owning foreign currencies backfired during that episode.

Figure 1: U.S. Dollar Index during COVID-19 Panic

That action explains how hedged-currency equity mandates tended to have more muted downside than the MSCI EAFE Index (MXEA), which rode the currencies as they oscillated. The WisdomTree International Hedged Quality Dividend Growth Fund (IHDG) provides an example (figure 2).

Figure 2: COVID-19 Crash Performance from MSCI EAFE’s 1/17/20 Peak to Mid-Year 2020

Standardized performance for IHDG is available here. 

During the COVID-19 crash, it was simple:

Challenging Preconceived Notions

There are three common theories: 

1. Having foreign currency exposure helps mitigate portfolio risk
2. Hedging currency is expensive, regardless of reality
3. The U.S. dollar (USD) will weaken

The first theory we disagree with, the second is wrong and the third is a weak argument unless the investor is table-bangingly bearish  USD. 

Before we get into it, look at figure 3 to fully appreciate this market’s sleepy persona—for now (figure 3).

Figure 3: 3-Year Currency Volatility, MSCI EAFE Countries

Addressing Theory #1: Is Having Foreign Currency Exposure Useful?

Since the MSCI EAFE Index launch in 1989, the cumulative annual gain from its component currencies has been just 0.1%. But that stability over 30+ years masks several bouts of intense action. MSCI EAFE component currencies witnessed annualized standard deviation of 7.5% in that time.

For what? For basically no reward. Sure, there were sometimes diversification benefits, but the 14.7% annualized standard deviation of stocks in their local markets ends up rising to 16.8% when tracked with currency layered on top (figure 4).

Figure 4: Currency Effect on MSCI EAFE Risk/Return

In the other “pain year”—2020—foreign currencies rallied 6.97%, but all of that came in the recovery months, not the panic period.

Looking at the rest of the time frames, the prospect of gains or losses in any given year is a coin toss. If foreign exchange is hedged, all the chart’s bars collapse to zero. We think that means fewer sleepless nights.

Figure 5: MSCI EAFE Index Calendar Year Returns from Currency

 

Addressing Theory #2: Hedging is Expensive

According to our Capital Markets team, bid/ask spread “slippage” from trade execution may cost investors in currency-hedged developed market equity funds just a basis point (bp) or two annually.

Also, currency hedging costs are directly tied to relative interest rates. Because so many other central banks pin overnight rates in negative territory while the federal funds rate is slightly above 0%, U.S. investors get paid to hedge.  

Addressing Theory #3: Precipice of a Secular USD Bear Market

How about the investor that is steadfastly dollar bearish? Consider this: U.S. portfolios’ heavy bias to domestic large caps may already reflect that view.

We estimate that U.S. multinationals earn nearly half their profits abroad. When the dollar rallies, earnings have historically taken a hit from the currency translation. When it weakens, earnings have risen.

That means hedging forex to dollars has often ended up giving much-needed help in investment returns during the tough times—when Wall Street is reporting disappointing financial results. 

It’s something to think about.