The Trade-Offs of Hedging
In its research report, Vanguard made the point that it can be expensive to hedge foreign currencies and that this represents a high hurdle for how much a currency has to depreciate to overcome this high cost.
The truth today is that hedging foreign currencies is only expensive in some cases—particularly emerging markets such as India and Brazil—but can be inexpensive for Europe and Japan.
The Interest Rate Differentials: An important cost of currency-hedged strategies is embedded in the nature of how currency hedging works, which is the interest rate differential between the currency of the investor’s home market and the interest rate in the currency the investor is looking to hedge.
In markets that have much higher interest rates than the U.S.—e.g., Brazil or India—the cost to hedge the currency can be very high, currently as much as 7% per year.2 The graph below, which shows the current interest rate differentials, illustrates the divide between certain developed and emerging markets.
The Divide between Developed and Emerging Markets
Three currencies—euro, yen and British pound—make up approximately three-quarters of the MSCI EAFE Index weight, and the cost to hedge each of them is less than .25%.3 One might actually get paid something more meaningful to hedge the yen, given that interest rates in the U.S. may increase before those in Japan do, as can be the case if interest rates in an investor’s home country are higher than in the country of the currency being hedged (as is the situation of the Swiss franc; see above).
The bottom line of this cost discussion: currently, the costs are minimal in the developed world and high in some emerging markets. With a practically free option to hedge the risk in Japan and Europe, is it worth taking the risk again for no expected return enhancement in the long run if currency returns are a wash?
What Volatility Reduction?
Vanguard also argued in its report that there is only a marginal benefit to volatility reduction for equities but that currency volatility can dominate fixed income returns, so that is where currency hedging pays, according to them. Recent facts suggests otherwise.
Over the last five years, the volatility to European equities with euro exposure4: 26.2%
Over the last five years, the volatility to European equities5: 18.1%
Volatility contribution of the euro: 8.1%
That is, the euro exposure increased the volatility to European investments for U.S. investors by 8 percentage points. In other words, fully 30% of all the volatility for European equities came from the euro.6 The 30% contribution of total volatility is the same over the last decade (22.9% total volatility, including 6.1% currency volatility).7 I would say that is a meaningful amount of volatility to come from currency risk.