International Equities: Currencies Matter

Hedging out the currency risk from international equities is currently en vogue after investors in the Japanese equity market dramatically enhanced their returns by hedging out the yen exposure in 2013. Market participants investing in international equities, must ask themselves: “to hedge or not to hedge?” As we shall elaborate, investors might be asking the wrong question.

When investing in international equities, the return stream generated can be broken into equity returns and currency returns. As the chart below shows, between 30% and 50% of monthly equity index returns, when measured in U.S. dollars, were attributable to currency fluctuation1:

The contribution works on the upside, as well as on the downside. In a month where the local country’s stock market moved up, it is possible a good portion of the gain may be attributed to currency appreciation. Similarly, in a down month, a good portion of the loss may be attributed to currency depreciation.

Let’s look at the correlation2 between the currency moves and these markets. For a currency-hedged international equity investment to enhance returns, one would want a rising equity market and a negative correlation between equities and the exchange rate:

For currencies with positive correlation with the local stock market (e.g., euro), hedged investors may get a buffer when European stocks go down (by avoiding the double loss from both stocks and the euro), but lose the upside when European stocks go up (in which case the euro usually goes up). 

For currencies with negative correlation to the local stock market (e.g., Japanese yen), hedged investors may get higher returns when the Japanese stock market goes up (by avoiding the loss in the yen) but lose the buffer when Japanese stock market goes down (in which case the yen usually go up).

If the yen continues to have a negative relationship with the Japanese stock market and the Nikkei rises, then it might make sense to hedge out the currency risk. However, note that this trade hasn’t worked well this year with a falling Nikkei and a rising yen.

One of the reasons that investors may want to hedge the local currency exposure is because they feel they have an edge on making directional calls on broad equity markets in various countries but don’t understand the currency markets or don’t have a directional view on a given local currency. It would be frustrating to get the equity market call right and still lose money in U.S. dollar terms because of local currency fluctuation.

Rather than hedging or not hedging, investors may want to consider actively managing currency risk. Not hedging and taking a leap of faith on up to half the returns on a return stream appears imprudent to us. But conversely, eliminating the potential value that currencies may bring provide can lead investors to leave returns on the table.

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( Courtesy of http://www.merkfunds.com/fund/ )