I believe it’s necessary to take a harder look at the diversification attained by adding in this FX risk. If investors evaluated FX as a pure standalone investment instead of a package product, I think they would rarely find themselves convinced of the reason to add in this exposure to their portfolios. There has been rising correlation of FX to the S&P 500, low historical returns to FX, high historical volatility and a tactical environment that looks likely to favor the U.S. dollar.
It is fairly easy now and rather inexpensive—especially on a relative interest rate basis—to hedge developed world FX exposure to currencies like the euro and the yen. I think more and more U.S. investors will come to this view in the coming years.
For more research on the declining diversification of layering in foreign currency on top of equity risk, see our market insight here.
1One example of a product that does add two exposures in this format is tied to the S&P 500 Gold Hedged Index, which provides exposure to both the S&P 500 and gold—in a sense to hedge exposure to purchasing power of the dollar relative to gold. This product effectively provides two sets of exposures for a given $1 invested in it—$1 in the S&P 500 and $1 in gold. Japanese investors use this type of “double decker” strategy, often taking Japanese equities and adding a high-yielding currency exposure on top of them.
2Source: Bloomberg, as of 8/15/14. References Bank of Japan, European Central Bank and Federal Reserve policy rates of 0.1%, 0.15% and 0.25%, respectively. Cost of hedging estimate based on one-month forwards using interest rate differentials.
Important Risks Related to this Article
Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Diversification does not eliminate the risk of experiencing investment losses.