Bill Bernstein: Beware The Currency Hedge

June 11, 2015

The eye-popping inflows into currency-hedged equity strategies over the past two years might be mistaken for shrewd investment decisions on the part of all the investors and advisors who have plowed billions of dollars into them. Not so, according to Bill Bernstein, who views the astonishing success of currency-hedging strategies like the now-$20 billion WisdomTree Europe Hedged Equity Fund (HEDJ | B-47) as the latest examples of hazardous performance-chasing.

But Bernstein, a devout passive investor and author of several books on investing, doesn’t stake out a position that hedging or not hedging is absolutely the right call. Instead, he counsels investors, as he always does, to stick to their plans. And that advice extends to the question of whether to hedge currency exposure. Whatever their judgments, investors at all times must be consistent to maximize the probability of success. I wanted to discuss with you the currency hedging situation. The marketing machine is in full swing, and the more we can bring rigorous thinking to this phenomenon, the better. So what do you make of this craze?

Bill Bernstein: It's performance-chasing, closing the barn door after the horses have escaped. Walk me through what that means.

Bernstein: There's nothing wrong with hedging your equity exposure. But you have to have a consistent strategy. If you're going to hedge your currency exposure, then you should do it 100 percent of the time. Starting to hedge after a period of high hedging returns it is a bad idea.

I just came from Europe and I thought it was pretty cheap, especially the south; off-season, you can get a decent hotel for $100-$150 bucks a night. Contrariwise, whenever I thought that Europe was particularly or ridiculously expensive, that's when my thoughts did turn to hedging. But at times like this, that's when I think about increasing my currency exposure. I mean, the euro is cheap. In other words, the dollar-strength trend has run pretty far, and for someone like yourself, who believes strongly in the notion of mean reversion—however it manifests—this may be time to go neutral on currency exposure?

Bernstein: Yes. But to me, being currency-neutral means having all of your foreign equity exposure unhedged, but no currency exposure on the fixed-income side. Then you’ve certainly been on the right side of history in the past decade and a half. And perhaps not so much in the last 18 months to two years.

Bernstein: Yes, exactly; but it's also been the most efficient way to do things. It costs money to hedge, and there are tax consequences too. During the good years, you wind up with these distributions that aren't favorably treated under tax code; it's not capital gains when you currency-hedge returns of profit. So it's ordinary income; is that essentially …

Bernstein: It gets complicated, but it sure isn't capital gains; it's different every time I look. But it's not pure long-term capital gains. Last year, there were some notable exceptions to the general tendency of low capital gains—and they were in connection with currency hedging, which is exactly what you're saying, right?

Bernstein: Yes, exactly. What I would seriously be thinking about at a time like this—and not quite just yet, but if things got to be even more extreme, certainly the euro and the buck at parity—would be doing something I very rarely do, which is having exposure to currency on the bond side. The problem with that at the moment is you're buying duration, which is probably not a smart strategy.

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