Over certain periods, of course, currencies can provide a tailwind that serves to strengthen returns for international investors who are not hedging their exposure (like the period from June 30, 2001, to March 31, 2008, where currency returns boosted the MSCI EMU Index by almost 10% per year5), but they can also be a big headwind for those who may be unhedged, as they have been for European equity investors since the euro peaked out at around $1.60—it is now trading at around $1.33.6
Currently, the default allocation for most investors in foreign equities is to take 100% exposure to currencies on an unhedged basis, regardless of one’s outlook on the foreign currency’s potential strength or weakness compared to the U.S. dollar.
I think investors should consider the following model for foreign equity investing:
1) Investor has no conviction on currency direction: 50% hedged currency exposure, 50% currency exposure
2) High conviction that foreign currency will rise: 100% currency exposure
2) High conviction that foreign currency will fall: 100% hedged currency exposure
Of course there are many points in between these three baseline scenarios. I believe most investors have no real conviction on potential currency performance but still take on the full currency risk. To me, that is the wrong baseline. More investors should start with a 50% hedged currency position as a baseline and then dial up or down the currency exposure or currency hedge depending on their views and their level of conviction.
The currency I have the most fundamental questions about—beyond the yen—is the euro. We have focused our research and index development on European equities that would benefit from a weaker euro, notably exporters such as Daimler Chrysler, BMW, Unilever, Bayer, Anheuser Busch InBev and other multinational corporations that have a global revenue base. Many of these exporters had very positive euro returns as the euro fell, even as the broader MSCI EMU Index declined after the euro peak (led by declining financials). While past performance is not indicative of future results, I expect these European exporters could potentially continue that positive performance if the euro were to weaken further versus the U.S. dollar.
Bottom line: Investors should consider how much conviction they have in the potential performance of the euro against the U.S. dollar—and if the answer is that they have no idea as to its future direction, which I suspect is the case for many, they ought to consider hedging that risk, if they are truly trying to capture the equity opportunity.
Jeremy Schwartz is director of research at WisdomTree Investments (NasdaqGM: WETF). This post was republished with permission from the WisdomTree blog.
1Refers to the MSCI Japan Local Currency Index. As of 12/31/2012, the yen has been the weakest currency of the 12 represented in the MSCI EAFE Index compared to the U.S. dollar on a 1-month, 1-quarter and 1-year basis. Of the 22 market indexes represented in the MSCI EAFE Local Currency Index, the MSCI Japan Local Currency Index has ranked 1st, 2nd and 8th over these same periods. Source: MSCI.
2Based on an analysis of flows to European ETFs. Source: IndexUniverse.
3Refers to the negative correlation exhibited between the returns of the yen measured in U.S. dollar and the returns of the MSCI Japan Local Currency Index, with a specific negative 3-year correlation measured as of 12/31/2012.
4Source: MSCI.
5Source: MSCI.
6Bloomberg.