By Jeremy Schwartz, CFA, Director of Research
How many people think it is a smart idea to take their exposure to U.S. equities and layer on top of it-dollar for dollar-an additional exposure to the U.S. dollar? This type of layering additional risk might be called a form of leverage, as an investor would be providing two sources of return for a given dollar investment. For example, consider a $1 investment in a hypothetical fund that provides exposure to $1 of U.S. equities and $1 of exposure to the U.S. dollar ($2 of distinct asset class risk for every $1 invested). Few long-only investors in the U.S. desire this strategy, and I have rarely seen anything like this exposure offered to investors in the U.S.
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?
When investors buy overseas assets, they have to sell U.S. dollars and buy euros or yen to purchase those overseas stocks. Unless a currency (foreign exchange, "FX") hedge is made to mitigate this FX risk, investors are fully exposed to FX fluctuations.
Recently, currency-hedged equities have gained traction to neutralize the FX risk and target the local stock market returns. I have been talking to clients about currency-hedged strategies for much of the last five years, and virtually all conversations start like this: "Why should I hedge my currency risk?" But that is perhaps the wrong starting point. A more natural starting point to me is this: Why is it beneficial to add currency risk on top of local equities? Let's go through common rationalizations.
One answer to why many take on the FX risk: a misperception that it is expensive to hedge foreign currencies. This can be a valid concern in some countries today: Brazil, India, South Africa and Turkey, for example-all countries that have very high short- term interest rates when measured against U.S. interest rates. I'd agree the case to hedge these emerging market currencies is diminished, as there is a higher hurdle for how much these currencies have to depreciate for the hedge to pay off.
But the cost to hedge developed world currencies such as the euro and the yen has been brought down to virtually zero because all their interest rates are pegged near zero. Central bankers have been guiding us to believe that the U.S. Federal Reserve will be the first major central bank to increase short-term interest rates. The European Central Bank and the Bank of Japan have set their forward guidance to keep interest rates low for a long period-so it is possible to collect some interest to hedge the euro and yen at some point in 2015. This environment makes currency hedging particularly relevant in the developed world today.
The next two arguments I hear for taking on currency risk:
- Currency provides diversification to my portfolio.
- U.S. dollar bears want protection from a falling U.S. dollar.
I am going to explore each premise in some detail here. I believe one can make just as strong a case that the U.S. dollar should appreciate versus at least half the most common exposure to developed international currencies (the euro and yen).
But even if one is a U.S. dollar bear, I will provide an additional question as to what the best equity investment would be given a bearish U.S. dollar bias. Hint: It's close to home. I also will discuss why the "diversification" argument also seems unconvincing-or at least why the historical diversification foreign currency provided to U.S. investors appears to be declining.
Reality Check For U.S. Dollar Bears
The historical three-year cumulative impact currency has had on the MSCI EAFE Index for U.S. investors is charted below. This is the additional exposure from FX an investor gets unless that FX risk is hedged. One of the clear signs on this chart is that FX can really enhance or drag down returns significantly. There was a three-year period when the FX added 80% cumulatively to the returns of the MSCI EAFE. But there also have been times when FX subtracted more than 20% cumulatively on a three-year basis.
This additional return component has gone from a fairly large booster in the late 2000s to a drag, with the most recent three-year stretch as of July 31, 2014.
Where Does FX Go From Here?
One of the most important variables in exchange rates is interest rate policy set by the central banks. Below are two statements that come from the head of the Bank of Japan (BOJ) and the European Central Bank (ECB).
Haruhiko Kuroda on August 8: "A reversal of excessive yen rises has had a pretty big positive impact on Japan's economy, such as a pick-up in corporate capital spending. ... The Federal Reserve continues to taper its asset purchases, while the BOJ and the ECB continue to maintain ultra-loose policies. I don't think there is any reason for the yen to rise."
Mario Draghi on August 7: "Fundamentals for a weaker exchange rate are today much better than they were two or three months ago":
- Monetary Policy Divergence: "monetary policies in the euro area and in the United States are, and are going to stay, on a diverging path for a long period of time"
- June's Actions: "monetary policy announcements of last June have been successful. They have been successful, not only the various monetary policy announcements, but especially so the negative deposit rate"
- Positioning: "There has been a quite significant increase in the short positions on the euro... Other central banks have been reducing their exposure to the euro. And if you look at how markets are expecting real rates to be for the foreseeable future, meaning until 2019, current expectations are that real rates will remain negative in the euro area for a much longer time than they will be in the United States. I think that is one of the major developments that I would pick up from what happened in the last three, four months."
As the U.S. completes its quantitative easing (QE) program while the Bank of Japan ramps up its program and the Europeans consider more monetary policy actions, U.S. dollar bears need to face the reality that the U.S. dollar may be strong for a considerable period given shifting stances among central banks. A speech by James Bullard, the president of the Federal Reserve Bank of St. Louis, talked about the impacts of easier monetary policies such as QE. Bullard suggested that the ECB should go down a similar route as the Federal Reserve (Fed), because QE largely accomplished its mission in the U.S. Bullard attributes QE to easier monetary policies, which historically have resulted in, among other things, currency depreciation. Euro weakness is part of the prescription many suggest to help Europe reinvigorate its economy and spur some inflation.
QE effectiveness from Bullard: "Traditional effects of "easier monetary policy" include (1) higher inflation expectations (2) currency depreciation (3) higher equity valuations (4) lower real interest rates. All of these have been associated with QE in the U.S."
Going FX Neutral By Currency Hedging
Investors who take on FX risk must recognize that they are implicitly expressing a bearish view of the U.S. dollar. Without a hedge, an investor is implementing a tactically bearish view on the U.S. dollar when holding foreign equities-but this does not have to be the case. Currency-hedged options could allow an investor to be neutral with no opinion on the direction of the U.S. dollar by just targeting the local equity market return.
An investor who is bearish on the U.S. dollar can selectively add in FX or other asset classes to capitalize on this view. Based on historical correlation data, international stocks do not appear to be the best positioned to capitalize on an FX rally or weak U.S. dollar environment.
One asset class that had been increasingly benefiting from a fall in the U.S. dollar: the S&P 500 Index. Data shows the S&P 500 has become strongly negatively correlated to its currency and as strongly negatively correlated as it has been in 40 years. Some fund flow and asset class flow reasons are accentuating these correlations, but there are also business and economic reasons that explain this pattern.
Next to Japan, the S&P 500 is one of the strongest negatively correlated markets to its currency. And the reasons may be similar. A growing share of revenue and profits for U.S. corporations comes from overseas-and that number seems only likely to increase with globalization of the economy. Weakening of the U.S. dollar supports revenue and earnings that come from overseas. For a U.S. dollar bear, perhaps the best option is thus to invest more in the S&P 500 and other multinationals in the U.S., along with FX separately. As I will discuss later, when these foreign currencies rose in value versus the U.S. dollar, their returns were often not all that attractive.
What About Diversification?
Does FX provide a level of diversification not offered by the local equity markets? If an investor had to decide to allocate to EAFE FX as just 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 periods 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.
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.
I thus struggle to understand the rationale to take on EAFE FX risk given the volatility profile, the rising correlation to the S&P 500, the lack of return expectations from FX investing and the very low cost of hedging these currencies today.
The Declining Diversification Of Owning The Euro
On the next page are the same charts for the European FX correlation to the S&P 500, which also show 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.
Do You Really Want To Own Yen With Japan Equities As A Diversifier?
The Japanese yen, evaluated on a standalone basis, looks like an interesting asset class to diversify S&P 500 exposure, as the yen displays a negative correlation to the S&P 500 over the 40 years of data and a sharper negative correlation in more recent years.
But does this mean one should take on the yen risk by packaging it on top of Japan equities? Not necessarily, as the Japanese yen is even more negatively correlated to Japanese stocks than it is to the S&P 500, and Japanese stocks can thus take a bigger hit if the yen rises.
The three-year correlation of the S&P 500 and the yen was -0.33, but the three-year correlation of the yen and the MSCI Japan Index (in yen) was -0.74. If one really wanted a hedge for a bearish scenario in the U.S. equity markets, the historical correlation data would suggest the yen could serve that choice as a standalone investment, but not unless it's packaged with Japanese equities. It's possible to see the yen rising during a time when the U.S. economy slowed down significantly or China's economy had a particularly bad stretch. That does not seem to be a time one would want to own Japan's stocks.
The historical volatility profile of the yen and Japanese equities also reveals an interesting characteristic. During the period I call "the Abe period," I show how a strongly weakening currency of almost 20% led to significant gains in the equity markets-up almost 70%. This led to higher volatility for Japanese stocks. But this was volatility that should be desired-stocks doing well as the currency is declining. The fact that packaging the equity risk and currency risk lowered volatility does not seem like a desirable goal for international equities; rather, it is the ultimate reason to own many of these foreign markets.
Japan Is Not A Unique Case
Japan’s case study of having quite strong returns when its currency was declining is not unique through history. Earlier I discussed how the S&P 500 was showing a strong negative correlation between the U.S. dollar and the S&P 500. Over long-term periods, the MSCI EAFE Index performed better measured in local currencies when the EAFE FX was declining and so did the MSCI EMU Index. The MSCI EMU Index has a little less than 30 years of data, but the differentials are striking-14.5% average annual returns when currencies were declining versus just 1.4% average annual returns when the EMU FX was rising. These points illustrate that some of the best returns to foreign markets came when currencies were declining and the U.S. dollar was rising - but one must hedge the FX risk to achieve those returns.
Whereas many traditionally have thought that getting bullish on the U.S. dollar should mean allocating less to foreign stocks to avoid the FX hit, the reverse is actually true: One should increase exposure to foreign stocks when the dollar is rallying, just in a currency-hedged manner.
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.
But if one started with a clean slate, I believe one would say that adding currency risk on top of the equity market is actually more exotic than currency hedging. The example that started this piece of the S&P 500 and U.S. dollar packaged together should illustrate that case fairly clearly.
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.
Ask yourself this: Why am I taking FX risk in my international portfolio? It is fairly easy now and rather inexpensive-especially on a relative interest rate basis-to hedge developed world FX exposure to currencies like the euro and the yen. I think more and more U.S. investors will come to this view in the coming years.
Unless otherwise stated, data source is WisdomTree.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information visit wisdomtree.com. Investors should read the prospectus carefully before investing.
Diversification does not eliminate the risk of experiencing investment losses. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.
Investments focused in Japan are increasing the impact of events and developments associated with the region, which can adversely affect performance.
Investments focused in Europe are increasing the impact of events and developments associated with the region, which can adversely affect performance. You cannot invest directly in an index.
Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.
S&P 500 Index: A market capitalization-weighted benchmark of 500 stocks selected by the Standard & Poor's Index Committee, designed to represent the performance of the leading industries in the United States economy. MSCI EAFE Index: A market cap-weighted index composed of companies representative of the developed market structure of developed countries in Europe, Australasia and Japan. MSCI EMU Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the markets in the European Monetary Union. MSCI Japan Index: A market cap-weighted subset of the MSCI EAFE Index that measures the performance of the Japanese equity market.
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Jeremy Schwartz, Director of Research
As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."