The currency conundrum: When to hedge?

This year, the strong dollar has worsened international asset returns for U.S. investors. Chris discusses whether that means it makes sense to hedge currencies going forward.

“To hedge or not to hedge?” That is the question many investors are asking this year, given the dollar’s rally, which has eaten away at returns of international exposures for U.S. investors that did not hedge that currency impact.

For example, the MSCI Emerging Markets Index is down around 12% this year (as of 9/11/08, according to Bloomberg). However, the MSCI Emerging Markets 100% USD Hedged Index is down less than half of this number with a -5.9% return.

In short, 2018 has underscored that currency exposure matters when investing internationally. For U.S. investors, if the dollar gets stronger, that exchange rate translates into lower returns for the international holdings. If the dollar gets weaker, the opposite occurs, boosting returns. Given that the U.S. dollar on a trade-weighted basis is up more than 5% year-to-date against a basket of developed and emerging markets currencies, the currency move has impacted portfolios.

For emerging markets, large currency moves this year detracted from the performance of international indexes, a sharp contrast to the persistent rally in 2017 amidst a backdrop of little volatility. The Federal Reserve’s interest rate hikes in the U.S. have contributed to the tightening of global financial conditions. This, coupled with rising trade tensions have influenced a broad unloading of emerging market currencies. Chart 1 highlights how nearly all emerging and frontier markets’ currencies are down against the stronger dollar this year.

currency hedgingFinal

Where we go from here?

Looking ahead, the outlook for the U.S. dollar is dependent on fundamental economic growth as well geopolitical considerations. The dollar bulls continue to look for above-trend U.S. growth to support higher interest rates relative to the euro-zone, Japan, and China supporting the USD. Worries over escalating trade tensions could also prompt a risk-off move and flight to quality, which would also support the USD.

On the other hand, the dollar bears point to the fact that global growth ex-U.S. is stabilizing after decelerating in the first half of the year. Stronger international growth and a rebound in risk appetite would likely push the USD lower similar to the 2017 experience.

To hedge or not to hedge

Given the sell-off in foreign currencies against the dollar, US-based investors have benefited from hedging the currency effect this year. But that doesn’t mean it will going forward. When considering whether to implement a hedging strategy, it is important to keep three factors in mind:

First, foreign exchange markets are some of the most liquid markets in the world. Their responsiveness to changes in geopolitical risks, economic data, and monetary policy has tended to occur more rapidly than other asset classes. This makes currencies some of the most difficult assets to forecast, and potentially should not be a major consideration for long-term investors.

Second, developed market currencies tend to weaken after a strong rally–i.e. “mean revert”–in the long run, so betting on a continued multi-year move higher in the U.S. dollar may be difficult.

Third, as my colleagues in the BlackRock Investment Institute have noted, over the long run, currencies are more of a portfolio risk to manage, rather than an opportunity to boost returns. Hedging an international exposure where there is a long-term correlation between the local equity market and moves in the home country’s currency can lead to long-term portfolio diversification. Although the positive correlation means that the assets move in tandem, it can be a key tool in mitigating downside risk. This is intuitive as it diversifies the source of risk and return. Conversely, in a market with a negative equity to FX correlation, the relationship between the two assets are already diversifying.

In short, investors looking abroad need to consider the impact of currencies in the international portion of their investment portfolios across both stocks and bonds. With the rise of currency-hedged ETFs, investors now have the tools to express their view.

Funds to consider

HEEM–iShares Currency Hedged MSCI Emerging Markets ETF

HEFA–iShares Currency Hedged MSCI EAFE ETF

HEZU–iShares Currency Hedged MSCI Eurozone ETF

HAWX — iShares Currency Hedged MSCI ACWI ex U.S. ETF

Indexed to MSCI Logo 2 JPG

Chris Dhanraj is the Head of the ETF Investment Strategy team in iShares and a regular contributor to The Blog.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Index performance is for illustrative purposes only.  Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.

The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.

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