Should investors hedge the currency when investing in international equities?
Listen to On the Minds of Investors
Over the last 15 years, international equities have underperformed U.S. equities by a cumulative 270%. Currency played a role in this underperformance, subtracting 25%, as foreign currencies steadily weakened against the U.S. dollar. Investors are left wondering: should they hedge currency exposure when investing in international equities? The reality is that in the short-term currencies are impossible to predict, as they are prone to sudden swings. As Alan Greenspan once said about currency trading, “to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin.” Longer term, currencies do tend to revert to their fair value over time. As the U.S. dollar looks overvalued versus a basket of currencies, this suggests a depreciating trend over a multi-year horizon. Crucially, for portfolio construction, allocating to international equities on an unhedged basis helps to maximize the diversification benefits of the asset class and may boost long-term returns.
Despite coming into this year already overvalued, the U.S. dollar has appreciated 3.6% year-to-date. The biggest move occurred following Russia’s invasion of Ukraine due to: 1) a flight to safe haven assets (associated with U.S. markets), 2) widening growth differentials between the U.S. and the rest of the world, as growth downgrades have been larger in Europe (and China due to its “COVID zero” policy), and 3) widening interest rate differentials between the U.S. and other developed countries due to a quicker repricing of Fed rate hikes over the next 12 months. Given these risks, it is surprising the U.S. dollar has not strengthened more, suggesting some fatigue for this upward trend may be occurring.
Longer term, currencies should revert to their fair value based on structural economic drivers, such as trade balances (with the U.S. registering a record wide trade deficit in January) and growth and inflation differentials (which are less favorable for the U.S. than suggested by current currency levels). Based on these metrics, the U.S. dollar looks overvalued, suggesting a cycle of depreciation over a multi-year horizon.
In the short-term, currencies are prone to sudden swings; however, over the long term, currencies have an expected return of 0%. In other words, hedging currencies could have a short-term impact to total returns but that impact diminishes over time. Unless investors have a definitive view, performance of currencies can be impossible to accurately predict – and hedges come with a cost that eats into total returns. As long-term investors, the question of hedging currencies is much clearer: we would suggest allocating to international equities without hedging currency for two reasons:
- Maximizing diversification: An unhedged international portfolio has demonstrated a more attractive correlation to the U.S. dollar (-0.52). Investors tend to allocate to international equities to diversify portfolios – in order to achieve the maximum diversification benefit, that allocation should be unhedged.
- Boosting total returns: The average U.S. investor is overweight U.S. equities, and consequently has an abundance of U.S. dollar exposure. In an environment where the U.S. dollar is overvalued and may experience headwinds over the medium term, an allocation to unhedged international equities may not only achieve portfolio diversification benefits, but also contribute to total returns.
Monthly returns, 100 = January 2000
Unhedged international is represented by MSCI EAFE returns in USD and hedged international is represented by MSCI EAFE returns in local currency.