The Pros And Cons Of Currency Hedging

by: Christopher Dhanraj
Summary

With the dollar maintaining its strength versus other currencies, the question of whether to hedge that currency effect remains an important one for U.S. investors considering international exposures.

For many investors, taking currency risk is not a rewarded factor boosting returns over the medium to long term, as noted by my colleagues in the BlackRock Investment Institute. Instead, for most, long-term investors currencies are more of a portfolio risk to manage.

Investors looking abroad should consider the impact of currencies in the international portion of their investment portfolios across both stocks and bonds. With the rise of currency-hedged ETFs, investors now have the tools to express their view.

The currency conundrum continues.

With the dollar maintaining its strength versus other currencies, the question of whether to hedge that currency effect remains an important one for U.S. investors considering international exposures.

Although a strong dollar benefits U.S. tourists going abroad, for investors it can take a bite out of returns. Since returns in non-U.S. investments occur in local currencies, those returns may be reduced when translated into dollars in periods when the dollar is strong. If the dollar weakens, the opposite is of course true, and it can boost international returns.

Indeed, 2018 underscored why currency exposure matters in international investing, as the dollar was broadly stronger against both emerging market and developed market currencies. The Currency Hedged MSCI ACWI Index outperformed the MSCI ACWI Index by 3.5 percentage points.

In 2019, the dollar has continued to rally (figure 1). U.S. economic growth has outpaced the majority of major developed markets, which manifests in higher interest rates, and in turn, higher "carry" - or income from interest rate differentials - for dollar investors. In emerging markets, worries over escalating trade tensions have also prompted a risk-off move out of many EM currencies and into the U.S. dollar. All of this has led to a stronger dollar versus most currencies.

All else equal, the Federal Reserve's dovish pivot should reduce demand for the U.S. dollar, as it theoretically would lower short-term interest rates - the source of the dollar's attractive carry. However, many major global central banks have also taken a more dovish monetary policy stance - some more aggressively easing than their U.S. counterpart. Additionally, the balance of geopolitical risks continues increased uncertainty in Europe, Latin America, and Asia. As a result, the dollar has remained strong since the Fed announced its shift in policy.

This underscores how currencies are difficult to forecast given their complicated sensitivities to economics, geopolitical frictions, and broader market expectations. For many investors, taking currency risk is not a rewarded factor boosting returns over the medium to long term, as noted by my colleagues in the BlackRock Investment Institute. Instead, for most, long-term investors currencies are more of a portfolio risk to manage.

Still, undertaking a hedged currency position does offer the advantage of mitigating the foreign exchange risk from an international investment, and essentially seeking to obtain more exposure to just the equity market performance. For example, this year in the United Kingdom, the increased risk of a hard Brexit has weakened the pound, but a relatively strong underlying economy has kept the equity market relatively buoyed. This has translated to a 6.7 percentage point outperformance of the Currency Hedged MSCI United Kingdom Index year-to-date over the unhedged MSCI United Kingdom Index (figure 2). The conundrum, of course, is knowing when to deploy the currency hedged strategy.

In some cases, maintaining an unhedged currency exposure can provide diversification benefits, particularly when a country's equities and currency have moved in opposite directions historically, also known as the negative equity-FX correlation. In such cases, the relationship between the two assets can provide potential diversification benefits.

In short, investors looking abroad should consider the impact of currencies in the international portion of their investment portfolios across both stocks and bonds. With the rise of currency-hedged ETFs, investors now have the tools to express their view.

This post originally appeared on the BlackRock Blog.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.