5 Things about Currency Hedging

“The rise in the U.S. dollar may have American investors wondering if they should be hedging their international investments. That’s because a strong U.S. dollar can dent international stock returns. For example, when investments in the eurozone are translated back to dollars, it takes more euros to buy a dollar, cutting into dollar-denominated returns. We believe the decision to hedge currency exposure depends on your time horizon. If you’re investing for the short term, hedging might make sense. But if you’re investing for the longer term, you’re not likely to benefit much, if at all, from hedging.

Here, we are focused on hedging currency for international stock investments, not trading or investing in currencies or international bond portfolios. In a currency-hedged professionally managed portfolio, investment managers buy stocks as they would for a regular portfolio. The manager then adds short-term forward contracts, which are arrangements to exchange two currencies at a pre-agreed exchange rate sometime in the future—often 30 days. The aim is to minimize the effect of currency movements on the portfolio return. But minimizing the effect of currency movements doesn’t mean entirely eliminating them. Because currency hedges are often adjusted monthly, dramatic currency moves within that time frame can still create currency risk within a portfolio.

Here are five things—two positive and three negative—to consider when thinking about the impact of currency on your international portfolio.

1. Hedging currency can reduce volatility of returns

Currencies can be volatile and difficult to predict in the short term, resulting in unexpected impacts on returns. By reducing the impact of currency swings, hedging can help reduce volatility. During the first six months of 2015, the euro has moved either up or down by 1% on 29 trading days. Hedged returns can be accompanied by less volatility.

MSCI EAFE Index, rolling three-, five-, and 10-year returns, calendar years 1969-2014

Hedged returns can be accompanied by less volatility

Source: Charles Schwab & Co. Inc., Bloomberg. Volatility as measured by deviation of rolling period returns from average period returns (i.e. the difference between each 3-year return from the average 3-year return). Hedged returns are in local currencies; unhedged returns are in U.S. dollars.

 

2. Hedging can boost short-term returns

Hedging currency in international stock portfolios can boost returns during times of U.S. dollar strength. For example, over the past year, hedging has produced superior returns for investments in many developed markets.

Hedged returns have beat unhedged this year. A strong dollar has reduced unhedged returns

Hedging has not generally added to long-term returns

Source: Charles Schwab & Co. Inc., Bloomberg, as of 6/29/2015. Hedged returns represent stock indexes in local currencies; unhedged returns are in U.S. dollars. Past performance is no guarantee of future results.

 

3. Hedging offers little longer-term benefit

Despite the benefits investors might see in the short term, over the longer term (which we define as three years or more), currency exchange fluctuations tend to even out. That reduces the benefit of hedging currency.

Hedging has not generally added to long-term returns. Hedged returns were worse than unhedged more than two-thirds of the time

Hedging has not generally added to long-term returns 

Source: Charles Schwab & Co. Inc., Bloomberg. Hedged returns are in local currencies; unhedged returns are in U.S. dollars.

 

4. Hedging comes with costs

There are two components of costs to hedge currency:

  • The difference in interest rates between the two currencies in question, also called cost to carry
  • The spread in price between the buyer and seller, also called the bid/ask spread

In a forward contract, investors earn the interest rate on the currency they are buying and pay the interest rate on the currency they are short. For example, as of June 30, 10-year U.S. Treasuries were yielding about 0.65% after subtracting inflation while 10-year Japanese government bonds were yielding around 0.35%, so a U.S. investor hedging against the yen would net 0.30%.

Currently, U.S. government bonds yield higher real rates (after subtracting inflation) than those in Japan or the eurozone. That creates a positive carry, which can add to stock returns. For emerging market countries, the real yield tends to be higher than in the United States. That means American investors would experience a negative carry, or an added cost to hedge.

For most developed market currencies, the bid/ask spread, or cost of buying a hedge, is relatively small, around 0.05%, or 5 basis points. Spreads on emerging market currency hedges are typically higher, starting at 50-60 basis points.

 

5. Currency hedging can reduce diversification benefits

Part of the benefit from investing internationally is that currencies often move in different directions. These moves are one reason we usually see variation from year to year in which country records the best investment performance.

Hedging international stock investments may reduce the diversification benefit by making portfolios more closely tied to moves in the U.S. stock market. Additionally, currency hedging may be redundant for investments in large-cap companies, which may already hedge their underlying businesses from currency fluctuations.

Takeaway

Over shorter time horizons, currency hedging can benefit performance of international stock portfolios when the U.S. dollar is rising. Longer-term historical data has shown that hedging currency has not benefitted performance. For emerging-market stock investments, we believe hedging stock portfolios is unattractive because of the high costs. For investors who are interested in implementing a currency-hedged strategy, consider using diversified currency-hedged exchange-traded funds (ETFs) or mutual funds rather than currency forward contracts”.

 

By Michelle Gibley, CFA®, Director of International Research, Schwab Center for Financial Research

Source: http://www.schwab.com/public/schwab/nn/articles/Currency-Hedging-5-Things-You-Need-to-Know?utm_content=FAInsights&utm_medium=email&utm_campaign=Post%20Blast%20%28wealthadvisor%29%3A%20FINANCIAL%20ADVISOR%20INSIGHTS%3A%20Moving%20to%20a%20low-cost%20state%20could%20be%20a%20mistake%20that%20haunts%20you%20financially%20for%20years&utm_source=Sailthru&nr_email_referer=1&utm_term=Financial%20Advisor%20Insights

Disclosure: This website is a collection of public articles, and this communication is for informational purposes only. Nothing herein should be construed as my opinion, solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from publicly available sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.

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