Hedge Bog

Dollar's Wane Translates Into Investors' Pain

Profiting from currency fluctuations through hedging is harder than it sounds.
Photographer: Kiyoshi Ota/Bloomberg

A weaker dollar may be good for U.S. companies, but it’s no friend to many U.S. investors.

Treasury Secretary Steven Mnuchin rekindled concerns at the World Economic Forum in Davos last month that the Trump administration is fixing for a trade war. "Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin said.

If there was any doubt what Mnuchin meant, Commerce Secretary Wilbur Ross made it plain by adding that “a trade war has been in place for quite a little while, the difference is the U.S. troops are now coming to the rampart.”

The dollar quickly complied. The Bloomberg Dollar Spot Index, which tracks the performance of the dollar relative to a basket of 10 global currencies, fell 1 percent the day Mnuchin made his comments. It was down an additional 0.3 percent through Thursday even after Mnuchin sought to clarify his remarks and expressed support for a strong dollar.

Other Way

Following a historic run-up, the dollar has reversed course recently

Source: Bloomberg

And when the dollar moves, investors’ portfolios do, too. That’s because many of them own foreign stock funds, and those funds constitute two bets: one on foreign stocks and another on the currencies in which those stocks trade. When the dollar rises, investors lose money on the foreign currency bet, and when the dollar declines, the bet pays.

The dollar’s gyrations aren’t likely to affect long-term investors because currency movements tend to even out over time. The historical returns from U.S. and foreign stocks have been remarkably similar. The MSCI EAFE Index -- a collection of stocks from developed countries outside the U.S. -- has returned 9.6 percent annually from 1970 to 2017, including dividends, the longest period for which returns are available. The S&P 500 Index, by comparison, has returned 10.5 percent -- the slight edge coming from the run-up in U.S. stocks in recent years.

The difference is that the currency component adds volatility to foreign stocks. The standard deviation of the EAFE index was 16.8 percent during the period, compared with 15.1 percent for the S&P 500. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)

One way to tame that additional volatility is by hedging the foreign currency. In essence, hedging removes the currency bet and leaves investors with the return on foreign stocks from the local currency. The standard deviation of the EAFE index in local currency was just 14.2 percent from 1970 to 2017, even lower than that of U.S. stocks.

Smoother Ride

Currency hedging dampens the bumps from foreign stocks

Sources: MSCI, S&P, author's calculations

Investors have clamored for currency-hedged stocks in recent years, and fund companies have obliged. BlackRock Inc., for example, introduced its iShares Currency Hedged MSCI EAFE ETF in January 2014. By the end of 2015, the fund had attracted $3.8 billion, according to Bloomberg data.

It’s not just one fund. According to Broadridge, only 1.4 percent of flows to non-U.S. stock mutual funds and ETFs went to currency-hedged funds in 2011. By 2015, that number had swelled to 20.9 percent.

Back and Forth

The dollar's value relative to other developed countries' currencies has been reliably mean reverting

Sources: MSCI, author's calculations

It’s too soon to know whether investors are turning to currency-hedged funds for lower volatility or to bet on price swings in the dollar. If it’s the latter, they’re likely to have plenty of opportunities. The difference between the EAFE index’s rolling five-year returns in dollars and local currency has been reliably mean reverting, which implies that dollar strength in one period is followed by weakness in the next.

But profiting from those currency fluctuations is harder than it sounds, not least because it means buying funds that have performed poorly. Investors have shown little interest in that so far.

Consider that the dollar appreciated more from 2011 to 2015 than in any other five-year period up to that point since 2005, when the data start for the dollar spot index. As a result, the five-year returns for unhedged funds looked lousy in 2015. The EAFE index returned 4.1 percent annually in dollars from 2011 to 2015, but 8.3 percent -- more than double -- in local currency. If ever there was a time to favor unhedged funds, that was it. Instead, investors poured a record $45 billion into currency-hedged funds in 2015.

Hedge On

Investors poured record amounts into currency-hedged funds in 2015

Source: Broadridge

It hasn’t turned out well. The dollar has declined 9.2 percent since the end of 2015 through January. The EAFE index has returned 9.9 percentage points more in dollars than in local currency. And if the dollar weakens further, currency hedgers should brace for more pain.

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:
    Daniel Niemi at dniemi1@bloomberg.net

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