Here’s Why You Shouldn’t Currency Hedge

November 25, 2015

Currency-hedged ETFs are gathering assets hand over fist. With central banks engaged in a race to the bottom, hedging currency exposure is vital to protecting assets and capturing returns.

This topic is so popular that it’s the title of a panel at the Inside ETFs conference coming in late January. Here’s why you shouldn’t take the bait …

Intuitive Argument For Hedging

It’s absolutely natural to want to hedge international stocks—especially now. U.S. stocks have trounced international stocks in large part due to the soaring U.S. dollar. Not only is money flowing into hedged international stock funds, even legendary passive investor Burton Malkiel has wandered off the random walk and is chair of a new hedged emerging markets stock fund.

The argument is compelling from two fronts. The first would be that foreign currency is an added risk, as it has volatility against the U.S. dollar. Secondly, it’s pretty clear that the U.S. is having a faster economic rebound than most of the rest of the world.

More Compelling Argument Against Hedging

Though everything I’ve stated above is true, it’s not an argument to hedge. Consider these four reasons to say no:

Additional volatility does come from foreign currency fluctuations, but such volatility is actually a good thing. Over the past 20 years, the correlation of U.S. stocks to the U.S. dollar has been a relatively low 0.38.

Put another way, volatility with low correlation can make for a more stable total portfolio return, by which I mean that the volatility from foreign currency can often cancel out the movement from stocks.

While it is true that the U.S. economy is growing faster, that doesn’t translate to the dollar being stronger going forward. Forex futures markets are pretty efficient, and economic predictions are already built into them.

Then there is the fact that international hedging only became a hot topic after the dollar surged. Hedging would have actually been more helpful a few years ago when so many made a costly bet against America. It is playing out by money being poured into hedged international ETFs after the asset has done well, and that’s merely a sophisticated form of performance chasing.

Finally, if the previous four reasons didn’t convince you, remember that hedging foreign currency has costs, and those costs take from your returns.

Summing It Up

My instincts tell me that buying a hedged international fund makes sense. Yet I’ve come to realize that anything my instincts tell me about investing is typically wrong; for instance, buying after something has gone up, which typically doesn’t end well. It’s merely sophisticated fear and greed.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for AARP publications.

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