Should You Hedge Currency Risk When Investing Internationally?

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

Review – Which Broker Should I Use? Online Discount Brokerage Review

I’ve been through a few brokers already in my short investing career. I found answering the question, “How do I trade X?” to be a mysterious one in numerous cases. It turns out the answer was often much simpler than I originally thought.

In the interests of saving other investors some time, I’m going to share what I’ve learned. This is not an endorsement of any of the brokers mentioned, I am not an affiliate/referrer (though I probably should be if I am writing posts like this) and ultimately I don’t care who you use– YMMV.

First, some info tables

I created a few tables to compare online discount brokerage features. The first is a commission and fee schedule for Scottrade, TD Ameritrade/Think or Swim, Fidelity and Interactive Brokers. Please note, this is not exhaustive nor comprehensive, it’s just the info I care most about for the kind of trades I do:

Brokerage Name Scottrade TD Ameritrade Fidelity Interactive Brokers
Stocks (online) $7 $9.99 $7.95 $1/min, 0.5% of order max
Stocks (broker assist) $27 $44.99 $32.95
Stocks (intl) Limited, $7/$27 Extensive and reasonable Extensive and reasonable
Options (online) $7 + $1.25/contract $9.99 + $0.75/contract $7.95 + $0.75/contract $0.25-0.70/contract
Options (broker assist) $27 + $1.25/contract $44.99 + $0.75/contract $32.95 + $0.75/contract
Addtl Fees N/A N/A Activity fee minimum $10/mo

Next up is a comparison of international markets you can trade in with Fidelity and Interactive Brokers, “O” means you can trade there online, “BA” means you can trade there with a broker assist and a blank means no online trade (and potentially no access with a broker, either):

Country Fidelity Interactive Brokers
N America
US O O
Canada O O
Mexico O O
Europe
Austria BA O
Belgium O O
France O O
Germany O O
Italy O O
Netherlands O O
Spain BA O
Sweden O O
Switzerland O O
Norway O
Portugal O
UK O O
Asia
Australia O O
HK O O
India Indian residents only
Japan O O
Singapore O O
New Zealand O
Notes: Claims it can reach nearly any stock in the world via broker assist

For trading Net-Nets

Which is the best online discount brokerage for trading Net-Nets in the US? I’m going to go with Scottrade here. Unless the shares have some restriction or are trading for under $1, it is only $7 per trade making Scottrade by far the cheapest (unless you’re trading in size on IB).

For trading all common stocks (US and international)

For a wider scope, I go with Fidelity. It’s $7.95 in the US for online trades and although the fee varies by country elsewhere, I’ve generally found it to be reasonable. Fidelity claims you can get access to almost any equity market in the world through their brokers, as well. I like that there is no activity or account maintenance fee, as well, which is something that irks me about IB.

For trading corporate debt and cap-arb

I tried doing a capital structure arbitrage trade through IB and not only could they not locate the debt for me because it was a convert and they don’t do converts, I also found their interface to be so confusing I wasn’t even sure if I had bought the related options properly when I put the trade on. IB has a terrible interface and their trade documentation is similarly obscurantist.

As a result, I prefer Fidelity and TDA/ToS. I have found in a few situations that TDA/ToS actually was able to find me bonds that Fidelity couldn’t, which surprised me. But overall, they both work well.

Overall

Fidelity gets my overall vote and I do and will continue to do most of my trading through their service. I have been told by so many people that IB is the way to go but I just find the GUI to be too difficult to understand. It’s outside my circle of competence, it appears! For US Net-Nets, I’ll use Scottrade just to make my trading costs absolute bare-bones and for a hard to find bond I’ll call up TDA/ToS (although they have been stumped to find me certain securities, as well) but more times than not, I am placing trades through Fidelity.

Though, one thing I do like about IB is they offer an account where you can manage a pool of sub-accounts (up to 15) without having any licenses or anything like that, which could be a good option in the future if I ever want to try managing  OPM. Plus, if you ever set up an account with Covestor you must use IB.