Unfortunately, the answer is no. For long-term assets such as equities, returns from an unhedged portfolio should be similar to those of a hedged portfolio. Because of interest rate parity, one currency cannot appreciate relative to another forever or there would be an arbitrage opportunity to create riskless profits. Based on this premise alone, it’s neither good nor bad to hedge an equity portfolio, though there may be some slight net return drag from the cost of hedging strategies over time.
While currency hedging doesn’t significantly lower volatility or increase returns over the long term in equity portfolios, it may make sense for certain stock investors to hedge their currency exposure, including those who:
- Have more exposure to foreign assets. Investors in regions where market capitalization makes up a relatively small portion of the global portfolio may have more exposure to foreign currency. In these cases, it may make sense to hedge at least a portion of the equity exposure.
- Have a specific portfolio objective of minimizing global equity volatility. For most equity investors, the modest reduction in volatility that might be produced from currency hedging isn’t worth the costs. But for investors interested in equity strategies with the specific purpose of minimizing volatility, hedging currencies may be advisable. For example, Vanguard hedges currencies in our Global Minimum Volatility Fund because minimizing portfolio volatility is the primary objective of this fund, and over time, hedging equities on average, should modestly lower volatility.
It may help to hedge at least a portion of the equity portfolio under certain circumstances. But investors should avoid currency hedging for short-term market-timing purposes. Short-term currency movements are extremely volatile and notoriously difficult to predict because they are affected by a variety of unpredictable factors, including changes in macroeconomic policies and events such as natural disasters. Betting on currency is a tactical move, and the success rate is low.
You don’t plan or cancel a trip abroad because of the value of the dollar, and you shouldn’t overhaul investment portfolios either based on this factor. Vanguard’s analysis of the currency hedging question has led us to hedge currencies in our international bond portfolios, but not in our international equities portfolios. For us, hedging equity exposure isn’t worth the added costs in those strategies that still have considerably less than half their assets in international equities and that have broader investment objectives than controlling volatility.
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*Karin Peterson LaBarge, Charles Thomas, Frank Polanco, and Todd Schlanger, 2014. To hedge or not to hedge? Evaluating currency exposure in global equity portfolios. Valley Forge, Pa.: The Vanguard Group.
Notes:
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. All benchmarks in this chart do not have real-world operating, trading, or hedging costs. The use of index funds or ETFs in any investment strategy will have differing results because of differences in management costs, tracking error, and other factors.
Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments (stocks) to more conservative ones (bonds and short-term reserves) based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.
All investing is subject to risk, including the possible loss of the money you invest. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Bond funds are subject to interest rate risk, which is the chance that bond prices overall will decline because of rising interest rates, and credit risk, which is the chance that a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Currency hedging transactions may not perfectly offset the fund’s foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposures.
Kevin Jestice, CFA, CIPM, is a Vanguard principal and head of Vanguard Institutional Investor Services.