It’s been nearly impossible to ignore the news about the dollar, especially for those of us who are taking advantage of the upcoming vacation season to travel overseas. The greenback’s movement also has implications for investors.
One of the things I’m hearing most from colleagues and clients is that investors know they need to have a view on the dollar—whether it will go up or down—and also be very aware of their investing time horizon. Unfortunately, they’re still unsure of how to implement a currency hedged strategy in their portfolio. Of course, predicting exact currency movements is impossible, especially in today’s environment. On one hand you have the Federal Reserve angling to boost interest rates, while on the other, central banks in Europe and Japan continue efforts to lower rates, thus weakening their respective currencies. So let’s focus on the variable that’s easier to measure: time horizon.
Why Time Matters
Investors seeking to limit the effects of currency risk on their portfolios have a number of hedging strategies to consider, but what to do depends on investment horizon. A quick review of the numbers shows that there is a big difference in the risk/return ratio of hedged and unhedged strategies depending on how long you remain invested. The chart below shows developed market return/risk ratios and reveals that results vary significantly over time. Of course, it’s important to remember that currency returns are generally viewed, over the long term, as a zero-sum game. And, as we can see, over a 15-year period, hedged and unhedged strategies, as measured by MSCI (daily index returns from April 1, 2005 to March 31, 2015) produced nearly the same results. However, applying some form of currency hedged strategy may help reduce volatility. In the example below, at 10 years, there was a higher return/risk ratio for a hedged v. unhedged index. The differences keep becoming more pronounced as you look at shorter time periods. Over a 1 year time period, a 100 percent hedged portfolio would have resulted in a 0.8 risk/return ratio while 100 percent unhedged would have resulted in a -0.6 risk/return ratio.
How to Build a Hedged Strategy
When deciding how much of your portfolio should be hedged for currency risk, a good rule of thumb is to think about developing an asset allocation and hedging “policy” at the same time. To clarify my point, I’m including a simple risk-and-return illustration. Low risk/low return investments such as cash and U.S. bonds reside in the left corner and the potentially high risk/high return investments such as unhedged international equities in the upper right corner. The orange dot is where a hypothetical investor may indicate her risk tolerance.
Considerations for Investing Overseas
When you think about international investing, it is also important to recognize the distinct characteristics of each country that makes up a foreign region. Some of these features may or may not be correlated with the U.S., and this can affect the decision of whether or not to hedge and, if so, how much. Take a look at the annualized volatility over 10 years for a variety of single countries and international regions, as represented by MSCI:
We can see from the graph above that the annualized volatility over 10 years was consistently higher for unhedged positions than hedged positions and that different countries and regions had different levels of volatility relative to each other.
In short, your asset allocation should depend on how much risk you’re willing to take on any given investment. If you have a portfolio that is heavily weighted toward international investments, has high currency volatility or high correlation between the currency and the underlying assets, a higher proportion of currency hedged investments might be appropriate. If you are more risk averse, and your portfolio is more heavily weighted towards U.S.-based investments, has lower currency volatility, or low correlation between the currency and the underlying asset return, you may consider having a lower proportion of currency hedged investments. Whatever your risk tolerance, you may want to consider currency hedged as a way to help minimize the effects of volatility over the long term, regardless of short term dollar movement.
