By Eric Dutram, DWS
Currency hedging is a relatively new phenomenon for the Exchange-Traded Fund (ETF) market and it really only gained popularity in the past decade. This was largely due to the impact currency hedging had on returns in two specific cases; Japan and Europe.
Thanks to policies in both markets which saw local currencies fall against the dollar, investors who embraced hedged products during this time saw large levels of relative outperformance when compared to unhedged peers. Since then, currency hedging hasn’t been quite the blowout from a performance perspective and investors have arguably focused their efforts elsewhere, at least as measured by subsequent shifts in assets under management in the space.
But even if investors have put currency hedging on the back burner, the long-term case for the strategy remains. From the end of 1992 until 6/30/18, minimizing currency exposure for the MSCI EAFE Index led to an annual return increase of 44 basis points when compared to investing in the same stocks with an unhedged strategy (source: Morningstar as of 6/30/18). A modest but relevant level of yearly outperformance over a long time frame.
Reducing Volatility
While the potential boost to return is nice, there are other reasons investors may want to consider currency hedging. Namely, the impact of currency exposure on volatility.
We looked at the incremental volatility added—or subtracted—as a result of currency exposure for the MSCI EAFE Index over the last few decades, and the results are pretty astounding. Not only did currency exposure increase volatility across a variety of time periods, but it did so to an overwhelming extent:
Incremental Volatility from Currency (MSCI EAFE index 3/31/73–6/30/18)
| Time horizon | Number of rolling time periods | Number of rolling time periods currency exposure increased volatility | % of periods currency exposure increased volatility |
| 3 years | 509 | 452 | 89% |
| 5 years | 485 | 444 | 92% |
| 10 years | 425 | 416 | 98% |
| 15 years | 365 | 365 | 100% |
Source: DWS and Morningstar as of 6/30/18. Rolling difference in annualized volatility of monthly index returns.
Past performance does not guarantee future results.
Over any and every 15-year period from 3/31/73 to 6/30/18, currency exposure increased volatility for investors. Even stretching down to periods of only five years saw currencies increase volatility at least 90% of the time, while rolling three year time periods saw an unhedged approach increase volatility in 89% of cases.
Volatility Reduction in Focus
Intuitively this should make sense. Currencies can and often do move independently of stocks. And if foreign investing returns are a combination of equity returns and currency returns, removing a key part of the equation would reduce the variables involved and a potential source of volatility.
And just as important, in order to have the effect of reducing volatility, currencies would need to move in a very specific direction relative to equities. In other words, any time currencies and stocks moved in the same direction, this would potentially increase volatility. Any time stocks were flat and currencies were on the move, volatility would be increased. Currencies and equities would need to move in opposite directions—with currencies moving by less than equities—in order for a non-hedged strategy to have a reduction in volatility levels.
That is why taking out this uncertain factor has generally been a great way to reduce volatility. This is clearly confirmed by the historical data, particularly over long time periods, but over shorter ones as well.
Bottom Line
Nothing is a sure thing in the world of finance. But currency hedging’s ability to reduce volatility, at least from a historical look over long time periods, is as close as many of us will get. The historical data is hard to deny in this regard for the EAFE Index, as 365 out of 365 rolling 15-year periods saw currency exposure increase volatility. With numbers that definitive, there is little excuse for not currency hedging, particularly when it has not historically had an adverse impact on returns.
Read more about our approach to currency hedging.
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