Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Despite its recent stumbles, the dollar has had the hot hand for much of the last two years. The U.S. Dollar Index, which measures the value of the dollar relative to a basket of foreign developed market currencies, has advanced 18 percent since April 2014.

Conventional wisdom suggests that the dollar isn’t done yet. The Federal Reserve is looking for any excuse to raise interest rates, while Europe and Japan are desperately trying to reboot their economies -- a recipe for a stronger dollar.

Not everyone accepts that logic, however. As my Bloomberg News colleagues recently reported, hedge funds are abandoning dollar bets on the theory that, 1) the Fed will drag its feet on interest rates; or that 2) the prospect of higher U.S. interest rates coupled with overseas stimulus is already priced into the dollar (or possibly both).

This debate about what’s next for the dollar isn’t just theoretical blather. U.S. investors in foreign stocks have paid a steep price for the dollar’s rally. The MSCI World ex USA Index returned 2.4 percent annually from April 2014 to March 2016 in local currency (including dividends), but the return in U.S. dollars was a negative 4.5 percent annually over the same period.

Rising Dollar Blues
The dollar's two-year rally has put a dent in the U.S. dollar returns of the MSCI World ex USA Index.
SOURCE: MSCI

Fund companies have taken note and are clamoring to comfort beleaguered investors with a barrage of currency-hedged stock funds. BlackRock, for example, has introduced over 20 currency-hedged stock funds to its popular iShares lineup of exchange traded funds over the last two years. The iShares Currency Hedged MSCI Eurozone ETF alone has gathered over $2 billion in assets since July 2014.

Investors who are weary of a rising dollar may be tempted to pile into currency-hedged stock funds, but they should consider more than just the dollar’s two-year rally.

Dollar Down
The U.S. Dollar Index has declined 21 percent from January 1967 through March 2016.
SOURCE: Bloomberg

For starters, the dollar isn’t a smart buy-and-hold investment because you can’t expect a positive return in the long run. Sometimes the dollar will outpace other major currencies and sometimes it will fall behind, but ultimately the net return should be zero. In fact, despite its recent good fortune, the dollar has lost ground to other major currencies over the last five decades. The U.S. Dollar Index has declined 21 percent from January 1967 to March 2016 (the longest period for which data is available).

Up and Down
Positive rolling five-year returns for the U.S. Dollar Index have historically been followed by negative returns, and vice versa.
SOURCE: Bloomberg

The dollar’s five-decade decline would have undermined any attempt at currency hedging. The MSCI World ex USA Index returned 9.4 percent annually in U.S. dollars from inception in January 1970 to March 2016, with a standard deviation of 17.1 percent. By comparison, the return in local currency – a good proxy for currency-hedged returns – was 8.1 percent annually over the same period, with a standard deviation of 14.5 percent. (Standard deviation reflects the performance volatility of an investment, and a popular argument for hedging is that it helps smooth out the bumps.)

In real life, the returns from hedging over that period would have been even worse. Hedging requires more trading, which means higher trading costs that are passed on to investors in the form of higher fees. Vanguard estimates that these costs add up to 0.25 percent to 0.5 percent of a currency-hedged investment every year.

There’s also no guarantee that hedging will work, so the best investors can expect from currency hedging over the long term is a 0.25 percent annual drag on performance.

Parking in a currency-hedged stock fund until fears of a stronger dollar subside is not likely to yield any better results. Putting aside the fact that timing the dollar’s movements -– or any other market movements for that matter -– is famously difficult, this may be a particularly bad time to bet on the dollar.

The U.S. Dollar Index has returned 4.5 percent annually over the last five years through March 2016. The Dollar Index’s five-year annual return was greater than 4 percent on 67 occasions from January 1972 to March 2011, but the average subsequent five-year annual return on those occasions was a negative 6.1 percent.

That’s a killer for currency hedging. The local currency returns for the MSCI World ex USA Index trailed the dollar returns by an average of 7.7 percent annually over those subsequent five-year periods.

For investors chasing the latest currency-hedged stock fund, a rising dollar may be the least of their worries. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net