Reasons Currency Hedging Matters

May 22, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by David Garff, president of Walnut Creek, California-based Accuvest Global Advisors.

When it comes to U.S. investors making international allocations outside of the U.S., the topic of whether to hedge out non-U.S. currencies has become widely discussed.

Some portfolio managers and ETF providers insist that over the long run, currency moves end up being a zero-sum game, so there is no need to focus on them. Other portfolio managers and ETF providers contend that currency moves are significant and long-lasting, and thus are worthy of consideration as portfolio construction tools.

As we will show, we believe the latter to be true.

Setting Up The Deep Dive

Currency-hedged equity ETFs have become the fastest-growing segment in the ETF marketplace. You can’t go anywhere online, or read about international investing, without seeing “currency hedged” as part of the conversation. In more colloquial terms, these products are “white hot.”

So, are these products just being marketed because they are the hot thing, or do they really have some long-term benefit in portfolio construction?

To answer this question, we turned to MSCI data on several regional market segments; U.S., Europe, Japan, Latin America, Pacific ex-Japan, Emerging Europe. We looked at some larger baskets, including EAFE, emerging markets and the ACWI.

For purposes of our analysis, we are using the difference between the USD and Local Currency indexes to approximate the returns of the currency-hedged MSCI indexes. Admittedly this is a rough estimate, as the costs of hedging can sometime be nontrivial. The time period of our analysis is Dec. 31, 1994 to April 30, 2015.

Hedged Vs. Unhedged

The table below shows the returns of the market segments both hedged and unhedged. With the exception of Pacific ex-Japan, currency hedging seems to enhance returns for the investor. These differences are small in the developed world, with EAFE coming in only 23 basis points higher per year. In emerging markets, the benefits seem to be greater.

Full Period (12/31/94 - 4/30/15)
Annualized Returns Hedged Unhedged % Difference
USA 9.88% 9.88% 0.00%
Europe 8.44% 8.31% 0.13%
Japan 1.66% 0.76% 0.91%
Latin America 14.00% 8.88% 5.12%
Pacific ex-Japan 7.26% 7.57% -0.31%
Emerging Europe 15.69% 8.41% 7.28%
EAFE 6.03% 5.80% 0.23%
Emerging Markets 9.60% 6.41% 3.19%
ACWI 7.88% 7.57% 0.31%

Assessing Volatility

The table below shows a nice volatility reduction for the hedged investor in almost all areas of the world. Again, we see that hedging currency in emerging markets generates the greatest decrease in volatility. The only region of the world where this effect is minimal is in Japan. But even in a very broad developed benchmark like EAFE, currency-hedged investors get more than a 12 percent decrease in volatility.

Full Period (12/31/94 - 4/30/15)
Annualized Volatility Hedged Unhedged % Volatility Reduction
USA 15.20% 15.20% 0.00%
Europe 15.57% 17.93% -13.19%
Japan 18.12% 18.17% -0.25%
Latin America 21.37% 28.28% -24.41%
Pacific ex-Japan 16.18% 21.51% -24.79%
Emerging Europe 27.04% 30.88% -12.45%
EAFE 14.56% 16.59% -12.22%
Emerging Markets 19.37% 23.43% -17.31%
ACWI 14.27% 15.56% -8.26%

Identifying The Risks

The table below summarizes a quick calculation of return/risk, and highlights the differences between hedged and unhedged portfolios. In every case, the return/risk ratio of the hedged portfolio is higher. So over the long run, it seems that dollar-based investors that hedge will have more efficient portfolios. But the long run here is a long time. Do we reach a different conclusion if we shorten the time frame?

Full Period (12/31/94 - 4/30/15)
Return/Risk Ratio Hedged Unhedged Efficiency Difference
USA 0.65 0.65 0
Europe 0.54 0.46 0.08
Japan 0.09 0.04 0.05
Latin America 0.65 0.31 0.34
Pacific ex-Japan 0.45 0.35 0.1
Emerging Europe 0.58 0.27 0.31
EAFE 0.41 0.35 0.06
Emerging Markets 0.5 0.27 0.22
ACWI 0.55 0.49 0.07

Timing Matters

The table below shows the return differentials of hedged and unhedged investors over two time frames. First, we look at a 7-1/2-year period of a strengthening euro, and then a 6-1/2-year period of a declining euro.

Increasing Euro (11/30/00-6/30/08) Decreasing Euro (6/30/08-4/30/15)
Annualized Returns Hedged Unhedged % Difference
Hedged Unhedged % Difference
USA 0.34% 0.34% 0.00% 9.79% 9.79% 0.00%
Europe 0.30% 7.17% -6.87% 6.74% 2.80% 3.94%
Japan 0.79% 1.18% -0.39% 4.56% 2.72% 1.84%
Latin America 25.48% 27.25% -1.77% 2.10% -5.05% 7.15%
Pacific ex-Japan 9.14% 15.62% -6.48% 6.84% 5.09% 1.75%
Emerging Europe 20.81% 23.19% -2.38% -1.62% -8.19% 6.57%
EAFE 1.02% 6.38% -5.37% 5.95% 2.99% 2.95%
Emerging Markets 16.85% 18.69% -1.83% 5.46% 2.20% 3.26%
ACWI 1.81% 4.27% -2.46% 7.37% 5.86% 1.51%

We have purposefully picked time frames very close to the trough and peak of the euro, as to better understand what the worst-case scenario is for someone who gets their timing wrong.

As we can see, if you get the currency direction wrong, it can have significant effect on the returns. A Europe investor who is hedged, while the euro is going from essentially 0.9 to 1.60, loses almost all of their return (0.30 percent versus 7.17 percent). On the other hand, a European investor who is hedged while the euro goes from 1.6 to 1.1, adds 3.94 percent per year in returns.

Lower Volatility

The volatility reduction benefits of hedging hold during both increasing and decreasing euro environments.

They are particularly impressive during declining euro environments, with risk reduction of more than 25 percent, on average. In addition, the correlations of the currency-hedged versions of these indexes are all lower than their unhedged counterparts.

The obvious conclusion is that long-term investors probably only want to hold the foreign currency if they have a strong opinion that it will appreciate. It also makes sense to hedge a currency that investors feel will be weak.

What is less obvious is the conclusion that if you are neutral on the foreign currency (or have a long-term view that currencies are a zero-sum game) then investors would be well-served to hedge the currency exposure. The resulting lower volatility and correlations of the component parts will benefit the risk/reward profile of the overall portfolio.

Most clients, despite their claims to the contrary, don’t have a three- to five-year time horizon, much less a 20-year horizon. Long time horizons are necessary for the “currency moves are a wash” theory to apply.


As we have seen, currency moves can cut deeply if investors are on the wrong side of a large short- to intermediate-term move. Investors with shorter time horizons would do well to consider being dynamic between hedging and not hedging.

Currency-hedged ETFs are a great way to get these exposures. So, regardless of whether they are “hot” right now, or it feels like they are being over-marketed in the current environment, we believe they deserve serious consideration for a global investor’s portfolio.

Accuvest Global Advisors (AGA) is a registered investment advisor based in the San Francisco Bay Area. Founded in 2005, AGA has drawn considerable recognition in the industry for its work in building global strategies through the use of single-country ETFs. For more thought leadership and firm updates, visit, or email [email protected]. For a list of full disclosures, please click here.

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