I read a white paper by Tweedy, Browne entitled “How Hedging Can Substantially Reduce Foreign Stock Currency Risk” the other day. I actually find the title of the paper misleading because the way it’s written it sounds like they’re recommending you hedge your foreign currency exposure when investing overseas.
Instead, the finding of the paper seemed to be that for long-term investors, currency fluctuations are generally a wash over time and hedged and unhedged portfolios perform similarly.
Here’s a quick, bullet-point list of info from the paper:
- currency fluctuations are generally more extreme than stock market fluctuations (greater volatility)
- depending on whether or not home currency interest rates are higher or lower than foreign country interest rates, one can contractually lock-in either a cost or a gain from currency hedging operations
- the investor who enters into a hedging contract to sell forward the foreign currency of a country whose interest rates are lower than his home country’s interest rates will receive a locked-in contractual gain
- over long measurement periods, the returns of hedged portfolios have been similar to the returns of portfolios that have not been hedged
- “Over the 1975 through June 1988 study period, the compounded annual returns on hedged and unhedged foreign equities were 16.4% and 16.5%, respectively” according to one study
- According to TB’s own experience: “over the 15.75-year period from Jan 1, 1994 through September 30, 2009, the MSCI World Index (Hedged to US$) had an annualized return of 5.7%; this return was nearly the same as the return over the same period for the unhedged MSCI World Index, which had an annualized return of 5.8%”
- studies have generally indicated that the compounded annual returns on hedged foreign stock portfolios have been similar to the returns on unhedged foreign stock portfolios
- currency hedging is similar to selling short
- the cost to an investor of hedging foreign currencies through forward and futures contracts is approximately equal to the difference between interest rates in the home country and the particular foreign country over the contract period
Investor Adam Sues, who blogs over at ValueUncovered.com, wrote in to share Currency Hedging Programs: The Long-Term Perspective (PDF). I appreciate the link and have reproduced my outline notes of key take-aways below:
- Remember, the floating exchange rate system is relatively new as it began in 1973
- While median hedging impact numbers were close to zero in the Brandes Institute’s study, the range of outcomes was wide, with almost half outside the range of +/- 3% annualized; be prepared for extended periods of possible hedging losses
- Japanese and US-based investors have experienced more volatile hedging results than Canadian-based investors; UK investors have had more favorable outcomes from hedging programs than US investors
- As the timeframe lengthened, the impact of hedging overlays relative to long-term equity returns tended to diminish
- A US-based currency hedging program for a non-US equity portfolio would have suffered an average annualized 1.8% loss over the entire 34-year period since the start of floating exchange rates (passive hedging programs are costly for US investors in the long-term
- The dollar, when measured against other major currencies, has more often been at the extremes of valuation than in the middle
- Currencies exhibited significant volatility in the short term but generally have been mean-reverting in the long term
- Currency moves and the related hedging impact tended not to wash-out completely over time, and even for 5- or 10-year periods, the range of results remained wide
- Currency overlay managers have shown evidence of value-add, but this effect has been small relative to the size of overall currency impact
- Bottom-line: it’s appropriate for investors to choose either a hedged or unhedged benchmark, and then stick to it for the long-term
A House Rises 