Is Currency Hedging Worthwhile When Investing Overseas?

by: Larry MacDonald

When investing in foreign stocks, should you hedge the currency exposure? That is a perennial question and Francis Chou provides a thoughtful answer in the 2007 Annual Report of the Chou Group of Funds. He cited two research studies that confirmed his view hedging wasn't necessary for long-term investors.

One, by Lee Thomas (The Performance of Currency-Hedged Foreign Equities), examined the return to a U.S. citizen from investing in six foreign countries from 1975 through 1988, and found "compounded annual returns on hedged and unhedged foreign equities were 16.4% and 16.5% respectively"

The second, by Meir Statman and Kenneth Fisher (Hedging Currencies with Hindsight and Regret), also found that hedging didn’t matter over the long run: the “mean annualized return of the unhedged global portfolio was only slightly lower than the 8.6% mean annualized return of the hedged portfolio during the overall 1988-2003 period.”

But these study results pertain to past periods when imbalances in the U.S. economy weren’t as distended as they appear to be now. Perhaps the U.S. dollar could be under stronger downward pressures over the next decade or two? If so, one's hedging policy could make a big difference, with the edge going to unhedged positions.

Indeed, noted long-term investor Warren Buffett appears to be looking to increase his unhedged foreign portfolio. At Berkshire Hathaway’s Annual Meeting May 3, 2008, he outlined a strategy for increasing holdings in European companies because he felt the euro would hold its purchasing power better than the U.S. dollar over the longer term.

Maybe it makes sense for Chou to stay unhedged on his foreign bets too, as he prefers. His Canadian-based mutual funds have seen a huge climb in the Canadian dollar, so most of the damage looks like it has already been done. To hedge now would be suboptimal if the Canadian dollar is topping out and/or going into reverse.