The benefits of diversifying globally in order to achieve your investment goals, are huge.
With these benefits and opportunities, comes exposure to foreign currencies.
While there's little evidence that currency movements can be predicted...
As an investor, you still want to know if you should guard against (hedge) these currency changes.
Answering this comes back to your goals as an investor.
If you're looking at global stocks, trying to shield yourself from currency moves doesn't make a big difference. That's because stocks are generally more volatile than currencies, so the currency changes are negligible in comparison.
On the other hand, when it comes to fixed income (like bonds), protecting yourself from currency changes can be helpful.
Let's go deeper, looking at how currencies affect global stocks and bonds and whether playing it safe with currency protection is a good move.
Does hedging boost returns?
For British investors with unhedged international investments, a strengthening Pound reduces returns, while a weakening Pound increases returns. Which begs the question:
Should you hedge (or not) to boost your returns?
This chart from Dimensional shows currency returns from the perspective of a European investor with exposure to a basket of developed market currencies.
Between 1974 and 2017, currency returns relative to a basket of developed market currencies exceeded 8% in absolute value more than 40% of the time.
Currency returns have moved between positive and negative with about the same frequency, being positive nearly half the time (22 out of 48 years). In those years, implementing currency hedging would have lowered returns for investors. When looking at all the samples, currency returns have generally not deviated significantly from zero.
This implies that, while currency returns may be volatile in the short term, over the longer time horizons, choosing to hedge or not has little-to-no impact on expected returns.
Can you reduce stock volatility with hedging?
Some equity (stock) investors might hedge currencies to smooth out the ups and downs.
But if you've got a global stock portfolio, hedging currencies doesn't usually make a big difference in reducing volatility (see the chart below).
Stocks are usually more likely to change a lot in value compared to currencies. So, when you have a global investment in stocks without protection against currency changes (unhedged), the ups and downs in the value are mainly because of the stocks, not the currency.
This means that unhedged and protected (hedged) stock investments typically show similar levels of volatility, as the chart below shows.
Does hedging reduce bond volatility?
In the global bond market, using currency hedging is a useful strategy to smooth out return volatility.
This is because currency returns tend to be more unpredictable than returns from stable, high-quality bond investments.
If you don't hedge against currency changes, the ups and downs in a bond portfolio will mostly come from currency movements.
You can see in the chart below that even though the hedged and unhedged indexes have similar annualised returns (2.93% versus 2.97%), the hedged index has much lower volatility (1.34%) compared to the unhedged index (6.52%).
Unlike with stocks, hedging bond portfolios is an effective way to reduce volatility.
It makes sense that investors holding global portfolios should consider the impact of dealing with different currencies.
Research suggests that, if you maintain consistent global portfolio exposure, currency movements won’t drive returns.
Whether an investor should hedge currency exposure in a global portfolio depends on their specific goals and the nature of the underlying assets. In the case of stocks, research suggests currency hedging doesn't significantly decrease portfolio volatility.
However, for fixed income (bond) investors, hedging proves to be an effective strategy for reducing the volatility of returns.