Funds that hedge their currency risk can be an effective long-term strategy for investors, but achieving this lower volatility can create additional costs.
When investors purchase a foreign investment, they must first convert their home currency to foreign currency. Thus, after completing a transaction, they are exposed not only to the risks of the foreign asset, but also to changes in the value of the foreign currency. This increases overall risk, and these two risks aren’t simply additive.
The relationship between exchange rates and local market returns plays an important role in the behaviour of foreign assets. Most of the time, currency movements and returns are positively correlated, so currency risk usually adds to volatility.
For example, the exchange rate between the US dollar and British pound had a positive correlation with the MSCI United Kingdom Index denominated in pounds over the 10-year period through December 2017.
Thus, the volatility of this index denominated in dollars was higher compared with the index denominated in pounds. The opposite scenario is less typical but has played out in Japan over this period. The correlation between the MSCI Japan Index denominated in yen had a negative correlation with the dollar-yen exchange rate. Therefore, the returns of Japanese stocks in dollars were less volatile than those denominated in yen.
Locking in a Future Exchange Rate
Most currency-hedged funds use forward contracts to hedge currency risk. These contracts simply lock in a future exchange rate, and thus eliminate any uncertainty regarding where the currency of interest will trade in the future.
The volatility caused by currency fluctuations is relatively similar across foreign stock and bond indices, with small differences stemming from different currency exposures in each index. But bonds are less volatile than stocks on an absolute basis. Therefore, hedging currency risk from bonds leads to a greater reduction in total volatility as compared with stocks.
Expense ratios are the most explicit cost associated with an investment. In the context of currency hedged funds, expenses for funds that are diversified across a range of countries, currencies, sectors, and stocks are higher than the low-cost alternatives.
Our Morningstar Analyst Ratings are indifferent to currency hedging, however. We assign the same rating to equivalent hedged and unhedged funds. Our neutral view stems from the expectation that hedging won’t act as a long-term performance enhancer, that the primary benefit of some of these strategies is long-term risk reduction, and that the decision to hedge or not to hedge is specific to each individual case.