The U.S. dollar had a strong start in 2015. During the first quarter, the dollar hit a 12-year high against the euro,1 and an eight-year high against the Japanese yen.2
These gains—resulting largely from the relative strength of the U.S. economy compared to overseas economies—create a challenge for people with international investments. Stock and bond investments denominated in euros or yen look a lot less valuable when you convert them into U.S. dollars.
This isn’t to suggest that investors should think twice about investing abroad. Foreign assets offer the potential for diversification and other benefits that shouldn’t be ignored. But the situation has left some investors wondering whether they should try to hedge their portfolios against potential currency swings.
When you hedge, you try to minimize the effect of currency fluctuations on your portfolio by investing in assets that move in the opposite direction of your target currency. For example, if you think the euro is going to fall against the dollar, you might seek out investments that will rise as the euro weakens, negating the effect of the change.
There are several ways to hedge. You could short foreign currency futures, but doing so can be complex and expensive. For this reason, many investors opt for investments that do the work for them, such as exchange-traded funds (ETFs) or mutual funds that hedge currency exposure. Some ETFs and mutual funds state their hedging policy in their prospectus or annual reports. (If this information isn’t available, you could call the fund company and ask, though proprietary information may not be shared.)
Before deciding whether to hedge, you should remember that while currency hedging may smooth the performance of a portfolio when currency markets are volatile, it also removes some of the diversification benefit that comes from investing overseas. The dollar isn’t likely to be strong forever, and if it weakens the returns on overseas assets will get a boost.
In general, Schwab doesn’t usually suggest hedging currency exposure in equities because it can be costly. However, given the low yields on international fixed income investments, there may be a case for hedging this part of your portfolio, says Kathy Jones, Senior Vice President and Chief Fixed Income Strategist at the Schwab Center for Financial Research.
“The yields on many fixed income investments generally are going to be small—maybe less than or equal to what investors will get in the United States—so investors might want to ensure that currency swings don’t erode those thin returns,” she says.
1James Ramage, “U.S. Dollar Pushes to New 12-Year High Against the Euro,” The Wall Street Journal, 3/13/2015.
2“Dollar Rises to 8-Year High Against the Yen,” Reuters, 3/10/2015.