In 2014, the US dollar went on a tear. The currency strengthened versus all other major currencies, and not by a small amount. The US dollar gained 11.97% against the Euro, 5.92% against the British pound, 8.32% against the Australian dollar and 11.58% against the Japanese Yen.
If you were a consumer of foreign products, or vacationing overseas, this is a great thing. Your dollar buys more goods, more nights at a foreign hotel, more meals at that Michelin star restaurant in Paris.
However, if you are an investor in foreign stocks, the opposite is true. The strong dollar hurt your investment performance. Let me explain. Let’s say you were an investor in Toyota Motors, the Japanese car manufacturer. And let’s say that Toyota’s stock had a decent year, it went up 10% (not real numbers). But the Japanese yen declined 11.5% against the dollar. This means that your net return, as a US investor, is a 1.5% LOSS!
This was the reality in 2014 for US investors with globally diversified portfolios. Out of 22 developed countries, all but three had positive returns when measured in their local currency. However, measured in dollar terms, 15 of the 22 countries had losses. All told, the EAFE index of large non-US companies lost 4.90%. It would be a different story if the currencies were hedged.
That then raises the question, why are international equities unhedged?
Currency trading is speculation
If an investor were to hedge currencies in foreign investments, the only logical approach would be to hedge all currencies, rather than being selective. Selective hedging is essentially the same thing as trading currencies. After all, how do you decide which currency to hedge and which ones to leave unhedged? The problem is that most people do not succeed at currency trading. According to this WSJ article, “about two-thirds of individual foreign-exchange traders lose money.”
Hedging has a cost
Currencies are typically hedged by buying a futures contract for the currency being hedged. The cost varies depending on the currency being hedged, and the market’s perception of the future volatility of the currency. Suffice it to say, hedging is not free and should only be used if the value of doing so is greater than the expected cost. Of course, as noted in the previous point, the value is not known. There is only value if you are hedging a currency that subsequently declines.
Volatility and returns is a function of stock prices, not currency fluctuation
The graph below shows hedged vs. unhedged monthly returns going back to 1990. You can see that the two lines track very closely. The underlying stock prices drive the price movements, not the currency fluctuations.
Additionally, a paper by MSCI* concludes that “hedging does not systematically improve (or lower) equity returns.”
*MSCI Barra, “Global Investing: The Importance of Currency Returns and Currency Hedging” April 2011