Prior to the popularization of currency-hedged equity strategies, equity investments outside the United States included two trades:
One of the most widely held rationales for owning international currencies was the diversification potential, namely how currency volatility, when combined with the rest of the assets in a portfolio, would actually lead to lower overall volatility.
How Global Small-Cap Allocations Reduced Risk of the Russell 2000
Starting from a base of the Russell 2000 Index, a common benchmark for U.S. small-cap equity performance, we added developed international equities in 10% increments to the picture to see what would happen. Two primary questions warranted testing:
• Northwest Is Best: Within the chart, anything that pulls the data points upwards and to the left (in other words, “northwest”) is offering a greater risk/return trade-off compared to anything positioned further downwards and to the right. Adding international small caps in local terms consistently pulled the data points the furthest toward the northwest corner over the examined period.
• Lower Risk Than the Russell 2000 Index: Over the 10-year period shown, the Russell 2000 Index had average annual volatility of about 22.4%. International small caps with currency risk had 15.4%, or 7% less, average annual volatility over the same period. Taking away the currency risk brought the average annual volatility to 13.2%—more than 9% below that of the Russell 2000 Index.