Planning a European vacation this year? You may be excited about the strong dollar, which will increase your purchasing power overseas. But an appreciating dollar isn’t as good for U.S. investors because it lowers the returns of their international portfolios.
The issue of the strong dollar has come up in many of my recent conversations with clients who have asked me why Vanguard doesn’t hedge currency exposure in most of our international equity portfolios, including those in our Target Retirement Funds. This question is understandable in light of Vanguard’s decision to increase exposure to international equities in our Target Retirement Funds—essentially Vanguard’s model portfolios—from 30% to 40% of the funds’ equity allocations.
In addition, Vanguard hedges currency exposure in all our international fixed income portfolios. This leads some to ask: If hedging currency exposure works well for international bonds, why wouldn’t it work more often for international equities?
The answer to this question lies in the dramatically different effects that having exposure to different currencies has on the volatility of the fixed income and equity asset classes.
For bonds, currency exposure adds significant volatility to an asset that’s relatively stable in price, so the benefits of hedging currency risk generally outweigh the costs. Otherwise, the ups and downs of the currency markets would overwhelm the returns of international bonds.
Stocks, on the other hand, already have high volatility, so the effect of adding currency volatility has a relatively small impact on the overall risk of the investment. In this case, the benefits of hedging are much smaller, while the costs of hedging are about the same.
Not only is the overall reduction in volatility from currency hedging relatively modest in equity portfolios, but nearly half the time it actually has increased risk in these portfolios. Hedging’s impact on risk is based on two factors: the relative volatility of the asset compared with that of the foreign currency and the asset-currency correlation. And because the correlations between currency and equity returns have varied significantly across markets and over time, the optimal currency exposure varies, as does the impact of hedging on realized volatility in equity portfolios.
As a result, our research shows that a hedged equity investment was statistically less volatile than an unhedged investment for U.S. investors in just 58% of the ten-year periods from 1971 to 2013. In contrast, for fixed income, the percentage of times that we’ve seen currency hedging have a meaningful impact on lowering volatility is much closer to 100%.*
But what about returns?
Clearly, there’s a difference in the impact of hedging on portfolio volatility for equities and bonds, but what about investment performance? Can we meaningfully increase long-term returns by hedging currencies in equity portfolios?