A deeper look into currency hedging
Regrets. Most investors have had a few, and this year’s currency volatility has been another reminder of how unexpected movements in the dollar – and the investor reactions this may trigger – can impact portfolios.
Coming into 2018, there was a view that the dollar was likely to continue to weaken. A January 4th Reuters story pointed out that the dollar had just recorded its worst performance in 14 years in 2017, falling around 10%. The author noted experts expected that performance to improve in 2018, but at least at the start of the year, the “path of least resistance is down.”1
As it so happens, the dollar was up 3.53% against a basket of global currencies through September 20th, as measured by The Wall Street Journal Dollar Index.2 So much for predictions. For unhedged US investors, the strength in the dollar has had a negative impact on unhedged international portfolios. And, according to a Bloomberg story, fewer US investors hold currency hedged investments. Looking at ETFs, Bloomberg wrote that these funds had seen substantial outflows over the previous nine months, catching investors on the wrong foot as the dollar rallied during the year.3
That kind of reflexive reaction to short-term market moves has not usually been good for long-term returns. Over a three-year period, the WSJ Index has essentially made a round trip, starting at $88.76 on September 26, 2015 and ending at $89.01 on September 20th of this year. In between, it made stops at $93.50 and $82.97, among other waypoints. Any one of these could have resulted in an unhedged investor feeling the need to bail out. 2
Market data is what it is, and the advice of most investing experts is to ignore short-term volatility. Still, it’s human nature to react to changing conditions, particularly when financial assets are involved. In recent years, academics and others have recognized that to optimize outcomes you have to take into account how individuals behave in the real world. This is reflected in the growing influence of disciplines like behavioral economics.
One way to address this real-world behavior is by putting in place a 50% hedge on international investments, what we call the “hedge of least regret.” This can provide a cushion against dramatic dollar moves, up or down and, by softening the potential blow of unexpected currency volatility, help investors stay committed to a long-term investment program. It addresses both an objective need – hedging the impact of currency fluctuations – and, indirectly, investor behavior.
There’s another potential benefit, too, as we approach year-end: rebalancing an international portfolio to take advantage of potential tax losses in an unhedged or 100% hedged holdings while moving to a 50% hedged position.
As with currencies, we have seen the landscape shift in terms of the relative performance of US equity markets versus their global counterparts. The US stock market is currently outperforming other developed markets and has for much of the past decade. But that’s not always the case. A look at the returns of the S&P 500 versus MSCI EAFE (developed markets outside the US) shows periods of significant out-performance for non-US equities. Like most markets (and currencies), returns tend to be cyclical and subject to mean reversion.4 With this in mind, it’s hard not to conclude that International equities have a role to play in a diversified portfolio, and that a 50% currency hedge is a good way to get that exposure.
1. Kishan, Hari, ‘U.S. dollar troubles not over yet, but 2018 to be a better year,’ Thomson Reuters, www.reuters.com, January 4, 2018.
2. The Wall Street Journal, as of September 20, 2018.
3. Bloomberg Intelligence, ‘Currency-hedged ETFs: Why don’t you love us anymore,’ September 4, 2018.
4. Rhoads, Russell, CFA, ‘Comparing S&P 500 and MSCI EAFE Performance,’ www.CBOE.com, July 14, 2015
The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
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MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
S&P 500, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value and is one of the most common benchmarks for the broader U.S. equity markets.
The Wall Street Journal Dollar Index (WSJ Dollar Index) is an index (or measure) of the value of the U.S. dollar relative to 16 foreign currencies. The index is weighted using data provided by the Bank for International Settlements (BIS) on total foreign exchange (FX) trading volume. The index rises when the U.S. dollar gains value against the other currencies, and falls when the U.S. dollar loses value against the currencies.
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