- A strong U.S. dollar and greater currency volatility are having a significant impact on near-term market returns.
- The euro has already depreciated substantially against the dollar in recent months, and further declines may be limited.
- Some investors have responded by turning to currency-hedged exchange-traded funds (ETFs), but that approach has its own problems.
- In our experience, currency impacts may offset each other in the long run and extensive hedging is therefore often not worth the cost.
- Currencies have an impact on international and global portfolios at several levels, and may affect individual companies in distinct ways. A weak currency may benefit exporters, while lowering earnings of some multinationals.
- Selective hedging based on fundamental research is more appropriate. We favor limited currency hedging in equity funds.
- In bond portfolios, currencies can be a significant source of volatility and return. Therefore, hedging currency exposure is a crucial part of active bond investing.
Many Currencies Face Dollar Strength and Higher Volatility
Equity and Fixed-Income Investors Should Think Differently About Currencies
The recent strength of the dollar and its often negative impact on international and global stock portfolios contrasts sharply with the experience of the prior decade, when a weakening dollar tended to augment international investment returns.
The U.S. economy is improving at a much faster pace than many others around the world. Employment has risen and inflation remains low, and many investors expect the Federal Reserve to raise rates this year. Given the recent rise, many investors are questioning whether we’re in a prolonged period of dollar strength and wondering how much further the dollar may appreciate against other currencies.
It is impossible to know the precise timing of inflection points in currency trends. Foreign exchange markets often overshoot for extended periods, and there can also be periods of reversals within an extended bull market.
However, thanks to a number of major studies, we are able to draw some informed conclusions about the effect of currency translation (that is, currency losses and gains resulting from the conversion of non-U.S. investment returns into U.S. dollars) in international markets. Several studies have concluded that currency translation has often had a relatively modest effect on total stock market returns over the long term.1
Consequently, investors seeking to mitigate exchange-rate volatility through hedging should be aware that their efforts may have a relatively small impact on a stock portfolio’s longer term volatility and return. An extensive study by Credit Suisse found that, on average, risk reduction from hedging is “less than half of that obtainable from global diversification.” The researchers also found that the benefits of currency hedging decline with longer investment horizons.2
An international portfolio’s overall volatility is a function of the volatilities of its assets and currencies, as well as their correlations — the degrees to which asset prices and exchange rates move together. Stocks tend to be volatile, so the net impact of currency volatility over time has often been limited.
In contrast, the effect of currencies on bond portfolios has been significant over various investment horizons. Bond returns tend to be comparatively stable, so currencies are often the major source of volatility and potential return in global and international bond portfolios.
Currency’s Longer Term Impact: Relatively Modest for Stocks, Profound for Bonds Annualized market returns and volatility (five- and 10-year rolling periods)
Lost in Translation, Gained Elsewhere? Currency’s Multilayered Effect on Stocks
Some international investors view today’s global backdrop as supportive of an extended period of dollar strength. Whether you agree or disagree with that outlook, the case for fully hedging currency, or buying fully hedged investment vehicles, is far from compelling. Exchange rates may move in unanticipated ways that are beyond the scope of hedges. To be effective, hedges need to be adjusted to reflect shifts in a portfolio’s value and exposures. Costs can rapidly accumulate — especially in turbulent periods when hedges are most needed, eroding the total return potential. Recently, costs have been relatively low for some developed-country currency hedges, but pricing can fluctuate.
Beyond an awareness of the potential drawbacks of systematic hedging with forward contracts or other instruments, our decades of experience in international investing has also taught us that the net impact of currency can vary greatly from firm to firm. Fundamental research that reflects where costs are incurred and revenues generated is crucial. “In which currency is a company’s cost base denominated? What about its revenues? When analysts assess operating margins, they have to take a view on currency — it’s an integral part of identifying companies that could be successful longer term investments,” says equity portfolio manager Gerald Du Manoir.
Currency effects related to financial reporting, as well as the firm’s hedging policy and balance sheet liabilities, must also be weighed. “As an investment analyst at Capital, I quickly learned that often there’s limited visibility around hedges put on by corporate treasurers. That complicates the hedging decision for an investor, and suggests that systematic hedging may have unintended consequences,” says portfolio manager Andrew Suzman. “In my experience, fundamentals ultimately shine through. Companies getting their businesses right is typically what matters most over time.”
Recent experience offers numerous examples of the crosscurrents that can result from shifting exchange rates. For instance, the stocks of some Japanese exporters have generated strong gains for U.S. dollar–based investors, as yen weakness proved a net benefit by boosting competitiveness.
Toyota: Dollar Strength Has Boosted U.S. Revenues and Driven Investment Gains In all six years during the past decade in which the dollar strengthened against the yen, Toyota’s stock recorded gains in dollar terms.
Elsewhere, dollar strength has bolstered profits for certain Indian technology and pharmaceutical firms with substantial revenues from the U.S., helping offset some of the tailwinds resulting from the Indian rupee’s strength against the currencies of other key markets. And, across the globe, the currencies of many commodity-oriented economies have depreciated; this has resulted in lower costs (in dollar terms) for some energy and commodity-related firms, helping counter some of the decline in revenues.
In our view, a selective and limited approach to currency hedging in stock portfolios is often preferable. Some portfolio managers will hedge a currency exposure if they expect a sudden and large shift as a result of a policy change. For an income-oriented investor, maintaining stable income from international dividend streams is a priority, so currency hedging to a greater degree may sometimes be appropriate.
Currency Is a Key Investment Decision in Global Bonds
In bond portfolios, currency plays a crucial role in shaping the overall risk and return profile. Changes in exchange rates can result in elevated portfolio volatility — possibly diminishing the potential diversification and stability that a bond allocation can add to a wider investment mix. Alongside credit selection, sector, duration, curve and country allocation, currency positioning is one of the important active investment decisions that a bond manager can make.
In our view, the potential benefits of selectively hedging currency exposure in international and global bond portfolios are compelling. In addition to potentially reducing portfolio volatility, active currency management can enable international and global investors to diversify exposure to bonds, and to invest in issues with attractive local return potential (high yields and weak currencies sometimes go hand in hand). We also believe that currency is a discrete source of both risk and return in bond portfolios. “Selective hedging of currencies is one of the key ways in which a global bond investor can navigate through volatility and seek to add value,” says bond portfolio manager Thomas Høgh.