The Pros and Cons of Currency Hedging

With the dollar remaining strong, Chris discusses whether it makes sense to hedge currencies for international investing.

The currency conundrum continues.

With the dollar maintaining its strength versus other currencies, the question of whether to hedge that currency effect remains an important one for U.S. investors considering international exposures.

Although a strong dollar benefits U.S. tourists going abroad, for investors it can take a bite out of returns. Since returns in non-U.S. investments occur in local currencies, those returns may be reduced when translated into dollars in periods when the dollar is strong. If the dollar weakens, the opposite is of course true, and it can boost international returns.

Indeed, 2018 underscored why currency exposure matters in international investing, as the dollar was broadly stronger against both emerging market and developed market currencies. The Currency Hedged MSCI ACWI Index outperformed the MSCI ACWI Index by 3.5 percentage points.

In 2019, the dollar has continued to rally (figure 1). U.S. economic growth has outpaced the majority of major developed markets, which manifests in higher interest rates, and in turn, higher “carry” – or income from interest rate differentials–for dollar investors. In emerging markets, worries over escalating trade tensions have also prompted a risk-off move out of many EM currencies and into the U.S. dollar. All of this has led to a stronger dollar versus most currencies.

All else equal, the Federal Reserve’s dovish pivot should reduce demand for the U.S. dollar, as it theoretically would lower short-term interest rates – the source of the dollar’s attractive carry. However, many major global central banks have also taken a more dovish monetary policy stance –some more aggressively easing than their U.S. counterpart. Additionally, the balance of geopolitical risks continues increased uncertainty in Europe, Latin America, and Asia. As a result, the dollar has remained strong since the Fed announced its shift in policy.