Data over the last 10 years calls into question whether currency risk really provides meaningful benefits—as it unquestionably has increased the risk profile of global portfolios. The analysis below starts with the S&P 500 and blends 10% increments of a portfolio to either:
If currency did in fact add diversification over the period, then the blends that added incremental weight to the MSCI ACWI ex-US Index in U.S. dollars should show the best risk/return trade-offs.
Blending MSCI ACWI ex-US to S&P 500- Last 10 Years
04/30/2005 – 04/30/2015
• Lower Risk than the S&P 500 Index: Over the 10-year period shown, the S&P 500 Index had average annual volatility of about 17.4%. The MSCI ACWI ex-US Index (in U.S. dollars) had a 16.4% average annual volatility over the same period. Taking away the currency risk brought the average annual volatility down to 13.5%—almost 4% lower than that of the S&P 500 Index.
• Importance of the 50/50 Mix: We recognize that currencies tend to move in waves and that this 10-year period might be one in which foreign currency exposures faced a particular headwind. Therefore, an interesting baseline could involve looking at mixes of the MSCI ACWI ex-US Index that were 50% in local terms (i.e., without currency) and 50% in U.S. dollar terms (i.e., with currency). This would minimize the risk of being fully exposed or unexposed to fluctuating exchange rates, given that there is no way to know precisely how they might behave in the future.
If the last 10 years are any guide, the real diversification of international exposures comes not from holding currency on top of equities but rather from just the equities themselves. With many investors questioning the valuations in U.S. equity markets, now is a very natural time to be looking at foreign allocations that are priced at lower valuation multiples than the U.S. markets.
But a big question is whether one should take foreign currency risk when going overseas. Many feel the dollar has strengthened already and they missed the opportunity to hedge their currency risk. But this long-term analysis shows why hedging can be an important part of strategic allocations to foreign markets to achieve a lower risk profile for global portfolios.