Dan Irvine | Principal
3Summit Investment Management, LLC
- Currency exposure from investing in international developed and emerging markets should not be hedged due to the high probability of reducing long-term returns resulting from additional costs.
- Hedging currency exposure may reduce volatility while also resulting in a loss of diversification benefit of holding foreign securities.
International investing does introduce an additional risk to a portfolio in the form of currency risk. The question becomes what is the best approach to managing this risk? Essentially, two options are available to U.S. investors: hedge currency exposure back to the U.S. dollar or do not hedge currency exposure and accept the associated risks. Before selecting the best approach, the nature and potential magnitude of additional risk presented to the portfolio must be understood in addition to the costs associated with hedging.
Understanding currency risk
Holding foreign denominated securities in a portfolio introduces additional risks through exposure to foreign currencies and the exchange rate risk present when converting between the U.S. dollar and the foreign securities underlying currency. The returns of any foreign denominated security are made up of two parts: returns generated from the underlying investment and the gain or loss generated as a result of changing exchange rates. Currencies can be volatile and so the exposure to multiple currencies has a tendency to increase portfolio volatility.
The table above shows that over the last 5 years, an unhedged portfolio would have experienced a volatility about 2.7% higher than that of a hedged portfolio. This is not an insignificant number, as all else being equal it would appear prudent to hedge out the currency exposure within a portfolio. But first, it is important to examine the historical investment returns between a hedged and unhedged portfolio.
Impact of currency hedging on returns
In the short-term, unhedged and hedged portfolios often deviate from each other significantly; however, over the long-term (3-5 years), these differences tend to diminish. Recently, the U.S. dollar has appreciated in relation to most other currencies, which has made hedging a profitable activity. However, history shows that over the long-term these differences are likely to erode.
The tables below show the cumulative difference between a hedged and unhedged international portfolio, as well as the frequency of positive versus negative returns over longer rolling periods. The performance results between the two portfolios are very close to one another, but in both samples the unhedged portfolio beats out the hedged.
The fact that over longer time frames both portfolios yield similar results is not surprising given that fundamentally speaking, the exchange rate between two currencies simply reflects the difference between interest rates in the two countries. However, currencies do deviate from their fundamental value frequently in the short-term, but should average closer to their appropriate market value over the long-term. The appropriate value would simply be the difference in real interest rates (interest rate minus inflation) between two countries. Given the interest rates between two developed countries is usually minimal we would expect little variations in investment performance between a hedged and unhedged portfolio over longer time frames. For the less developed emerging markets, the differential of real interest rates can be much higher, however this can lead to an increased cost of hedging as we will examine later.
The costs of currency hedging
What the analysis above does not include are the significant costs, both explicit and implicit, which are associated with hedging. When these costs are taken into account, hedging begins to look much less attractive. The costs of hedging include additional transaction costs, potential for increased tax liability and a reduction of diversification benefits from investing abroad.
Hedging currency exposure in a portfolio requires entering into derivative contracts called currency forwards for non U.S. dollar currency in the portfolio. The two costs of entering into a forward contract are “the carry”, which is the difference in interest rates and “the spread”, which is the bid/ask spread paid when trading. The carry can be positive or negative depending on the countries being compared, but the U.S. generally has lower real yields (yield after subtracting inflation) than emerging markets countries, which result in additional costs because of the negative carry. The bid/ask spread for developed currencies is usually around 5bps and more than 50bps for emerging markets currencies. This is a large cost considering the management fee of an unhedged international index fund can be as low as 8bps. The average management fee for a hedged index fund is about 35bps as a result of added complexity and trading costs. This is a major difference in cost and likely to dominate any long-term positive effects that can be gained from currency hedging.
If investing in hedged ETF’s, the fact that the fund is trading derivative contracts is likely to result in less tax efficiency as trading derivatives can result in distributable capital gains. This is only a consideration for taxable accounts, but should not be overlooked as any additional cost can have large impacts over longer time frames. A final potential cost of hedging is the loss of diversification benefit. The volatility of exchange rates across countries is a function of the different economic conditions in each country and the stage of the business cycle within each country or economy.
The exposure to these differing economic conditions, which is partially manifested in the volatility of exchange rates, is a major reason why international exposure improves portfolio diversification in the context of the entire portfolio. While hedging may succeed in lowering volatility of the portfolio, the correlation of the international holding to the domestic holding is likely to increase.
Long-term investors should not hedge out currency exposure
After looking at this issue closely, what emerges is that long-term investors should not hedge away the currency exposure of their global portfolios. When currency hedging is looked at within the context of the entire portfolio, currency exposure has historically increased diversification and enhanced long-term returns.