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.
If investors utilize a fully hedged or non-hedged strategy, it is important to understand that they are effectively making a currency call. For U.S. investors, 100% hedged or 100% unhedged strategies introduce an inherent view on the direction of the U.S. dollar.
We have coined the term “hedge of least regret” to describe a 50% currency hedged position. We believe that at least part of its potential benefit is discouraging investors from trying to time the currency moves by muting the impact of currency swings on both the upside and the downside. Sometimes it’s the trade you don’t make that works best.
A 50% currency-hedged international equity strategy may also help to provide a stabilizing effect on relative performance. As discussed earlier, there has been a frequent, often unpredictable, rotation between when a 100% currency-hedged or completely unhedged approach has outperformed. The 50% hedged route offers a more prudent return path that consistently delivers more balanced returns between these two extremes. These returns also highlight that the U.S. dollar does not always move uniformly across global currencies.
For example, during the period 2008 to 2013, a 100% hedged approach was never the strongest performer in the same year for both European and Japanese equity markets. The 50% currency hedge essentially removed the need to make a bet on the direction of the currencies.
Focus on Fundamentals
Exchange-traded funds have made it easier than ever before to invest outside the U.S., where almost two-thirds of global equity market capitalization resides. There are country funds, sector funds, regional funds, emerging markets funds – something for just about everyone and every portfolio strategy. But when it comes to currency hedging, the focus has generally been on two major currencies – the Euro and the Japanese Yen – and on an all or nothing approach. Over long periods of time, the currency trade may tend to even out. But in the real world of human behavior, market volatility creates stress, and may cause investors to act at times against their best interests (by trading excessively, for example).
This effect can be particularly acute for investors at or near retirement who may have scheduled withdrawals and may be forced to sell a position at the most inopportune times.
In the U.S., ETF investors had roughly 28% of their equity assets allocated to international equities as of February of this year, according to data from Bloomberg, the ICI, and ETF.com. Though this represents a significant underweighting relative to historical levels, it still has the potential to introduce volatility into the portfolio through currency exposure. And, as we all know, we have been living in volatile times.
The impact of eventual unwinding of the unprecedented interest rate policies pursued by global central banks since the financial crisis is yet another variable to consider. As the Fed and others move towards “normalization,” currencies will be affected, along with virtually every other asset class.
Election or no, investing outside the U.S. continues to provide diversification and other potential benefits. In our view, a 50% hedged position provides an attractive way to achieve this, allowing investors to focus more of their attention on the fundamentals of countries, companies, sectors, and growth and less on the relative value of currencies.