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%

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