The concept of hedging one’s currency exposure on international equity investments has been building momentum—especially in light of Abenomics taking hold in Japan during 2013. A primary question we see being discussed is whether a currency-hedged equity strategy belongs as part of a portfolio’s core international allocation or as a more satellite-oriented tactical approach.

Since unhedged strategies have been around longer, conventional thinking is that they are the default option and the “plain vanilla” approach to international investing. Today, WisdomTree offers a suite of equity exchange-traded funds (ETFs) which are unhedged covering international and developed markets. But, we also believe that currency hedging may make sense in certain equity markets. WisdomTree has a family of six currency-hedged equity ETFs.

I would argue that utilizing currency hedging to target the local equity returns could actually be the more “plain vanilla” approach. Let’s accept a common industry view that in many cases, currency exposures are a wash in the long run, meaning that they offer no expected return enhancement. If there is no expectation of positive return, what is the rationale for taking a secondary, ancillary currency bet that may substantially increase the risk profile of the portfolio?

Why is it that the vast majority of international funds are unhedged, offering exposure to both equity returns and currency returns? A Vanguard research paper in 20101 offered some of the conventional thinking, which we believe is worth referencing even today as the broader themes and ideas haven’t shifted much in the past four years:

“When we evaluated five major currencies, we found that, counterintuitively, currency hedging of a global equity portfolio provided only modest risk-reduction benefits. … Thus, if the costs of a currency-management program are nontrivial, any positive benefits will very likely be negated. Further, given the high volatility in the data, hedging of foreign-currency exposure did not produce any statistically significant value-added from a risk-adjusted-return standpoint.”

Vanguard makes a very important point about the costs of currency hedging, which we will further explore below. This is one of the most important points about the outlook for currency-hedged strategies over the coming years, and the currently trivial cost of hedging the euro or the yen makes these strategies attractive to us.

What Is Plain Vanilla?

Again, the central question, we believe, is why is the “plain vanilla” option to have both currency exposure and equity exposure combined in an unhedged format? The “plain vanilla,” I would argue—in the purest sense of the term “plain vanilla”—is pure local equity market return with no secondary “chocolate fudge” on top.

ETFs that provide both equity and currency returns should not necessarily be the definition of plain vanilla—and therefore the automatic default options for international equity exposure—just because they’re the oldest listed ETFs. One can argue that currency-hedged ETFs are more plain vanilla and a more natural starting point. Investors who have a positive outlook on the currency can start adding in the secondary currency exposure if they so desire.

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