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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: I can remember I could almost feel the steam coming out your ears when we talked about international bond funds and you said you eschew them generally, and that a nonhedged approach is the height of folly—it just runs afoul of everything about bond ownership.

Bernstein: Exactly. The last time we took on currency exposure on the bond side, in addition to on the stock side, was back at the inception of the euro in the early 2000s, when the euro traded as low as 85 cents on the dollar.

At that point, just like today, Europe was cheap. So the bottom line is, if you're thinking about currency hedging now, you’re effectively selling low, and if the currencies rebound, you’ll then be buying high when you close out the strategy.

ETF.com: So not that you're ever into this sort of speculative approach, but you're saying that you’re almost at that point, and that the dollar-euro parity might do it for you.

Bernstein: Yes. To me, the excitement over currency-hedged strategies is no different than the performance-chasing excitement you see when any other asset class does well

ETF.com: To be clear, you wouldn't take someone to task if they said: “Bill, I always hedge out currency. I don't care how expensive it is. And here's why.” You would have to give them some kind of respect because they're being consistent?

Bernstein: Yes. If they're being perfectly consistent, I think that's fine. One manager that's always hedged its currency exposure out in their equities is Tweedy, Browne. It’s very doctrinaire about that, and I respect that. What I don't respect are people who take their hedges on and off while looking in the rearview mirror.

ETF.com: What about someone who insists on 50/50? Do they get points for consistency, or do they get lambasted for wooly-headed thinking?

Bernstein:
The bottom line is, no matter what strategy you have, you should adhere to it. Variance in your strategy that is pro-cyclical—that is, you increase your hedging when the currencies depreciate, and you decrease your hedging; that is, you increase your currency exposure when the currencies get more expensive—is classic buy high/sell low behavior.

ETF.com: So how do you regard a global-macro kind of asset manager who bases the currency-hedging decisions on big events in the global economy, like the financial crisis, when everyone was panicking and putting things into U.S. Treasuries and other dollar-denominated assets?

Bernstein: Once again, as long as it's part of a rational contracyclical policy, I don't have a great problem with it. I think you're very likely to get egg on your face, but a contracyclical currency policy—one that increases the exposure when the currencies get cheap and increases the hedging when the currencies get expensive—you can make a rational case for that. That's not what you're seeing in print right now. What you're seeing in print is people getting excited about currency hedging after it's been profitable for a year.

ETF.com: Yes, and there's this overlay of intellectualizing and rationalizing the whole phenomenon, when in fact, I think I agree with you. It's pretty brainstem-y kind of stuff going on here.

Bernstein: You can describe, I suppose, four levels of currency strategy. The best, and most rational, efficient, cheap way of doing things is to not currency-hedge your foreign equities and only own domestic bonds, period. And just adhere to that.

Now, if you have a strategy where you have some degree of hedging involved—whether it's 100 percent like Tweedy, Browne does, or 50 percent—as long as you consistently do that, I think that's not bad. I think it's second-best.

Third-best is trying to contracyclically time the market, to adjust your hedges.

And then, worst of all is what you're seeing in print right now, which is doing it procyclically.

ETF.com: And that takes us back to your image of closing the barn doors when the horses are already out!

Bernstein: Exactly. Where were these geniuses a year ago?

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