The U.S. dollar’s 20% rise in relative value over the past year or so is proving to be a mighty strong headwind for international stock exchange-traded funds (ETFs) that are fully exposed to currency fluctuations.
No wonder investors have an increased appetite for investments that try to mitigate, or hedge, the impact of currency swings. According to Morningstar, assets in international stock ETFs that hedge their currency exposure have almost tripled in 2015, amounting to approximately $60 billion.
Tempted to jump on the currency-hedging bandwagon? Don’t act too quickly. Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory, cautions that employing currency hedging in your stock portfolio could in fact trip you up.
Why currency hedging looks attractive right now
While the U.S. economy is making gains, much of the rest of the world is struggling. As a result, many foreign currencies are weak compared with the U.S. dollar and thus convert into fewer dollars. So a portfolio that contains, say, German software behemoth SAP, which is priced in euros, or Honda Motors, which is priced in Japanese yen, is getting hit as the dollar flexes its muscle.
Hedging exchange-rate risk—buying financial instruments that counteract the effects of currency fluctuations—can soften the impact of currency swings.
Take the MSCI EAFE 100% Hedged to USD Index, for example. It tracks the same index of stocks from developed nations across Europe, Australasia and the Far East as the MSCI EAFE Index does. But while the hedged index gained 5.5% over the past 12 months, the index with no currency protection lost 7.5%.
So hedging might seem like a no-brainer. But Michael warns that while hedged international stock portfolios have worked as a tactical move in the short term, hedging may undermine your long-term strategy.
“You have to ask yourself why you are invested in international stocks in the first place,” he says. “Most likely, it’s for diversification, and currency diversification is part of the larger diversification argument. If you hedge your international stock portfolio, you are giving up an important layer of diversification.”
The long-term case against currency hedging
Indeed, if you’re focused on the long term, the smart move is to tune out the dollar’s surge and stick with your unhedged stock funds or ETFs.
While the dollar is having its day right now, Michelle Gibley, director of international research at the Schwab Center for Financial Research, notes that currency fluctuations tend to even out over time. And in hindsight, the time to hedge was in May 2014, when the dollar was 20% cheaper than it is today. Jumping in now presumes that you believe the dollar is going to keep rising in value from an already strong position.
History actually suggests that longer-term investors can tilt their odds toward better performance if they don’t hedge their international stock portfolio. As shown in the chart here, the unhedged MSCI EAFE Index beat the performance of the hedged portfolio in the majority of long-term rolling periods, dating back to 1969.
Exceptions worth noting
While patient long-term investors have reason to stick with an unhedged international stock portfolio, bonds are a whole other matter. If you own high-grade foreign bonds as part of your fixed income portfolio, the bulk of your returns tend to come from interest payouts, which are in the low single digits in most countries. This raises the risk that currency swings could wipe out your interest payment—and possibly the value of the bond. That’s why investors with foreign bond exposure might consider a hedged ETF.
Also, for some investors, a hedged approach to international stocks can make sense on a personal level. If you’ve learned enough about yourself to know that less volatility helps you stick to your long-term plan, adding a currency-hedged component to your stock portfolio can help smooth out the ride.
According to Morningstar, over the past 15 years the hedged version of the MSCI EAFE Index was 20% less volatile than the unhedged index. (Just remember that you may be signing up for lower returns over the long term than if you stick with an unhedged portfolio.)
Finally, Michael notes, retirees who are relying on investment income may want to consider hedging their international stocks. If you’re counting on international stocks to generate some of your income, you probably won’t be thrilled when a strong dollar cuts into your returns. By owning a hedged international stock ETF, you can help take currency swings out of the equation.