How many people think it is a smart idea to take their exposure to U.S. equities and layer on top of it—dollar for dollar—an additional exposure to the U.S. dollar? This type of layering of additional risk might be called a form of leverage, as an investor would be providing two sources of return for a given dollar investment. For example, consider a $1 investment in a hypothetical fund that provides exposure to $1 of U.S. equities and $1 of exposure to the U.S. dollar ($2 of distinct asset class risk for every $1 invested). Few long-only investors in the U.S. desire this strategy, and I have rarely seen anything like this exposure offered to investors in the U.S.1
If few U.S. investors would leverage up their S&P 500 exposure with a secondary bet on the U.S. dollar, why should it always make sense to layer on euro risk when buying European equities or yen risk when buying Japanese equities?
When investors buy overseas assets, they have to sell U.S. dollars and buy euros or yen to purchase those overseas stocks. Unless a currency (foreign exchange or “FX”) hedge is made to mitigate this FX risk, investors are fully exposed to FX fluctuations.
But why is it beneficial to add currency risk on top of local equities? Let’s go through 2 common rationalizations.
Isn’t it Expensive to Hedge?
One answer to why many take on the FX risk: a misperception that it is expensive to hedge foreign currencies. This can be a valid concern in some countries today: Brazil, India, South Africa and Turkey, for example—all countries that have very high short-term interest rates when measured against U.S. interest rates. I’d agree the case to hedge these emerging market currencies is diminished, as there is a higher hurdle for how much these currencies have to depreciate for the hedge to pay off.
But the cost to hedge developed world currencies such as the euro and the yen has been brought down to virtually zero because all their interest rates are pegged near zero2. Central bankers have been guiding us to believe that the U.S. Federal Reserve will be the first major central bank to increase short-term interest rates. The European Central Bank and the Bank of Japan have set their forward guidance to keep interest rates low for a long period—so it is possible to collect some interest to hedge the euro and yen at some point in 2015. This environment makes currency hedging particularly relevant in the developed world today.
What about FX as Portfolio Diversification?