Even as the results of the recent U.S. presidential election have roiled global markets, the case for investing internationally remains compelling.
More than half of the world’s equities exist outside the U.S. as measured by market cap, leaving the average U.S. investor considerably underweighted. While every market is different, international markets provide potential diversification as well as exposure to markets and companies that are growing faster and have more attractive valuations. Further, international economies are in earlier stages of monetary easing, possibly providing a further tailwind for equities.
Investing outside the U.S. poses many of the same challenges of stock and sector selection, while adding further complexity with regards to country weightings and currencies. Broad-based index products are one way to address the country and sector allocation challenge. Currencies are another matter.
Currency swings can and do have an impact on U.S. dollar investors over selected time periods. Anticipating what currencies are going to move relative to the dollar, and in which direction, has generally been an exercise in futility. A look at the pattern of money flow data in the Europe Hedged Equity (HEDJ – 100% hedged Europe) relative to the performance of the Currency Shares Euro ETF (FXE –EUR/USD) over the period August 2014 to March 2015 demonstrates the point. There were large flows into HEDJ after the euro had already declined relative to the dollar. The biggest inflows happened after the euro had already stabilized in March 2015.
This suggests that at best the hedging was ineffective; at worst, it proved counterproductive to portfolio returns.
The chart above presents another example, showing the U.S. dollar over a recent one-year period. Although the U.S. dollar was largely unchanged over the full period, it suffered through sudden and extreme moves throughout the period. Investors that were fully hedged or fully unhedged suffered through volatility that could have been mitigated with a partial hedge.
The Benefits of Currency Hedging
Currency hedging can provide a way to invest internationally while managing against the risk a stronger U.S. dollar can impose on foreign-based equity returns. A fully hedged portfolio can be immunized against a rising U.S. dollar. However, hedging can also reduce those returns when the U.S. dollar falls. The same fully hedged portfolio can erode the local equity market gains when the U.S. dollar declines.
History shows that the better-performing of the hedging strategies can vary from year-to-year and is difficult to predict. What’s more, the best-performing hedging strategy in one equity market might not be the best approach in another market during the same time period as different currencies may be moving in opposite directions vs the U.S. dollar. For example, year to date through October 31st, the U.S. dollar had declined more than 14% vs. the Japanese yen, gained more than 17% vs the British pound and was flat vs the euro.