Currency Hedging: 5 Things You Need to Know

Key Points

  • Over shorter time horizons, currency hedging can benefit the performance of international stocks when the U.S. dollar is rising.
  • Longer term, hedging currency has not historically benefitted performance.
  • For emerging market stock investments, we believe the cost of hedging stock portfolios is unattractive.

When the dollar is strong, should you hedge your international stock investments against currency losses? It's worth asking because when the dollar rises against the euro, for example, euro-denominated returns lose value when converted back to dollars. That can be a temporary drag on internationally diversified portfolio.

But hedging isn’t necessarily a simple yes-or-no proposition. We think your answer should depend 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, hedging could mean less short-term volatility, though it may not help with returns and you’d lose some of the diversification benefit of investing overseas.

So what constitutes a hedged portfolio? For our purposes, we’ll focus on managed portfolios or exchange-traded funds (ETFs) in which managers buy stocks or replicate an index as they would for a regular portfolio, and then add short-term forward contracts. That allows them 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. For example, if the euro falls against the dollar, and the portfolio manager has a contract to exchange the two currencies at a better rate than the current market rate, he can offset some of the currency losses from euro-denominated stocks. 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.

Before deciding whether to hedge, consider these two advantages and three disadvantages.

▲1. Hedging currency can help reduce volatility of returns

Currency movements 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.

Currencies can move sharply even within a single trading session. During the fourth quarter of 2016, 1% moves up or down occurred nine times for the yen, seven times for the pound and four times for the euro.

As you can see in the chart below, hedged portfolios have historically been less volatile than their unhedged counterparts.

Hedged portfolios may be less volatile

MSCI EAFE Index, rolling three-, five-, and 10-year returns, calendar years 1969-2016

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 three-year return from the average three-year return). Hedged returns are in local currencies; unhedged returns are in U.S. dollars. Past performance is no guarantee of future results.

▲2. Hedging can boost short-term returns

Hedging against currency losses in international stock portfolios can boost returns when the U.S. dollar is strong. For example, during the fourth quarter of 2016, a time of significant dollar strength, hedging produced superior returns for investments in many developed markets.

Hedged returns beat unhedged during the fourth quarter of 2016

A strong dollar reduced unhedged stock returns

Source: Charles Schwab & Co. Inc., Bloomberg, as of 12/30/2016. Hedged returns represent stock indexes in local currencies; unhedged returns are in U.S. dollars.

▼3. Hedging offers little longer-term benefit

Despite the benefits investors might see in the short term, over the longer term—say, three years or more—currency exchange fluctuations have tended to even out. That reduces the benefit of hedging.

Hedging has not generally added to long-term returns

Hedged returns were worse than unhedged more than 60% of the time

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 costs associated with currency hedging:

  • 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. The interest rate differential is based on the yields of government bonds.

Currently, U.S. government bonds yield higher real rates (after subtracting inflation) than those in many developed countries. The higher yield 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 could 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

One of the benefits of investing internationally is that currencies 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 they provide 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 international-stock-portfolio returns when the U.S. dollar is rising—which we expect the dollar to do in 2017. And there are portfolio managers and investment products that do the hedging work for you. Longer term, hedging currency hasn’t historically improved the performance of international stock portfolios though it can help mitigate risk. Hedging emerging market stock portfolios, however, remains unattractive because of the high costs.

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