We have been exploring the case for layering in foreign currency (“FX”) on top of foreign equity returns. One of the most common arguments I have heard for taking on FX risk in international equity portfolios in an unhedged fashion is that FX can be a portfolio “diversifier.”

But does FX provide a level of portfolio and market return diversification not offered by the local equity markets? If an investor had to decide to allocate to the EAFE FX1 embedded in the MSCI EAFE Index as a standalone investment, let’s review the case.

• Over the history of the MSCI EAFE Index, EAFE FX has added 1.6% annually to the returns of the MSCI EAFE Index. This means the U.S. dollar declined by 1.6% per year over this period.

• This return stream had an annualized volatility of 8.4% per year, a little more than half the volatility of EAFE equities (in local currencies).

• The correlation of EAFE FX to the S&P 500 over the full 40-year period was fairly low—only 0.09. But note a very important correlation trend: This EAFE FX correlation to the S&P 500 has been rising consistently in recent periods. In the last three years, the correlation between EAFE FX and the S&P 500 was 0.64, so EAFE FX is not providing the same type of diversification as it did historically.2

Figure 1: MSCI EAFE Index: Return, Volatility and Correlation

More importantly, one has to wonder if the past gain in EAFE FX can be repeated. We know with hindsight that the U.S. dollar declined. But do we know the U.S. dollar will decline going forward? Theoretical models suggest there is no expected return to owning currency. So why does one want to take on this FX risk embedded in foreign equity exposure unless one is a tactical U.S. dollar bear?

• The correlation to the S&P 500 for EAFE with FX and EAFE with no FX shows practically no differentials over the last 3-, 5-, 10- and 20-year periods. There is a slightly lower correlation to EAFE with FX over 40 years of data, but that does not appear to be a compelling case to add currency exposure on top of the local equity market return given the uptick in total volatility from adding FX and the unpredictability of future currency moves.

The Declining Diversification of Owning the Euro

Below is the same chart for the European FX3 correlation to the S&P 500, which also shows a consistent increase and less diversification from holding euros on top of owning the European equities.

• The European FX as a standalone asset class historically had 10% volatility consistently over most major periods—again, just about half the volatility of the local equity market.

• The long-term returns to the MSCI EMU Index currencies were only 0.1% per year—this means the risk-return trade-off for European currencies as a standalone asset class showed relatively miniscule historical returns with large volatility (a bad combination).

• EMU FX over the long run had a correlation of 0.14 versus the S&P 500, but that has risen significantly to 0.68 over the last three- and five-year periods. This rising correlation means there is less diversification benefit to owning the euro.4

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