Hedging What?

Story Highlights:

• Some investors are turning to currency hedging strategies in light of the weak dollar.
• Investors with strong convictions about a currency's extended direction can successfully use hedging to help minimize a portfolio's currency risk—if they're right.
• Transaction and opportunity costs can erase any benefits of currency hedging—particularly in the long term.

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Currencies fluctuate a lot, particularly in the short term. This is nothing new. Yet today's headlines nearly trample each other with breathless announcements of currency movements and subsequent explanations, predictions and analysis. But should stock investors care about currency movements at all?

If you're a US investor globally diversified among major developed nations, currency movements will probably have little impact over the long term—over time, currency moves tend to offset each other in your portfolio. Global equity portfolios inherently contain significant foreign currency exposure. As currencies fluctuate against the US dollar, so will the values of foreign equities priced in foreign currencies. Because currencies are zero-sum (i.e., if one currency goes up, by definition another is going down in equal measure, thus no net wealth is created or destroyed), currency fluctuations could actually help a globally diversified investor since foreign stocks rise in value relative to a weaker greenback. For example, if the yen appreciated 5% against the US dollar, an investor with $10 of his portfolio invested in a Japanese stock would gain 50 cents—regardless of stock performance.

Investors with a high degree of confidence in a currency's extended direction can successfully use hedging to help minimize a portfolio's currency risk—if they are right. An investor confident the US dollar will strengthen for some time might choose to hedge exposure to the euro or yen. One can hedge a number of ways, from simply shifting asset allocation to using financial instruments like futures contracts, forward contracts or options. Our aforementioned dollar bull, for instance, could simply overweight US stocks to moderate the impact of a rising dollar.

Over longer time periods, exchange rates tend to even out, erasing benefits from hedging currency exposures in a global equity portfolio—something to keep in mind if you're in it for the long haul. Even in the short term, exposure to natural foreign currency fluctuations adds diversification benefits because currencies and equity prices have a low correlation.

Currency hedging can also detract from performance through transaction costs and the opportunity cost of shifting a portion of the portfolio to the hedge from equities—especially in a rising stock market. If the portfolio is benchmarked to an index, hedging can add benchmark risk since benchmarks generally aren't hedged. Yes, hedging can detract from overall portfolio risk, but reducing currency exposure can mean lagging the benchmark markedly if your currency bet is incorrect.

Exchange rates are notoriously difficult to predict and subject to speculation and political manipulation. Without clear conviction of currency direction, a hedging strategy could be a detriment to portfolio performance. The tendency of currencies to offset one another over long periods means currency hedging is best used as a short-term tactic, rather than a useful long-term strategy. A long-term global portfolio of stocks has inherent diversification benefits built in—so hedging strategies could leave some investors wondering what they're really hedging against.