The US dollar has had a rough ride so far in 2017. The Federal Reserve’s Trade Weighted US Dollar Index that tracks the major currencies has tumbled roughly 8% year to date through last week’s close. The greenback’s slide, however, has delivered a substantial return premium for US investors who own foreign assets in funds sans currency hedging.
Consider the year-to-date performance for two ETFs that track the same index: MSCI EAFE, a popular benchmark of stocks in developed markets ex-US. The iShares MSCI EAFE (EFA) is up a strong 16.9% this year (through Aug. 15), nearly double the 9.2% for iShares Currency Hedged MSCI EAFE (HEFA). The reason for stark difference in returns? HEFA hedges foreign currency risk and EFA doesn’t.
The dramatic gap in year-to-date results for the two funds suggests that currency hedging is a losing proposition. It can be… at times. But the longer run of history of forex exposure (or the lack thereof) paints a more nuanced profile.
The main takeaway: there are no one-size-fits-all solutions for deciding if currency hedging is worthwhile. To understand why, let’s start by reviewing how the Fed’s dollar benchmark has fared on a rolling one-year-return basis vs. the one-year performance spread for a US$-hedged version of MSCI EAFE Index less its unhedged counterpart. As the chart below shows, mean reversion has been the dominant theme on both fronts over the past three decades. Periods of dollar strength have prevailed at times, but not for long. Over time, the dollar’s influence has been more or less a wash, at least for the one-year time horizon.
The results aren’t surprising. Most of the forex literature advises that currency trends, bullish or bearish, tend to be short-lived. A buy-and-hold investment in the Fed’s dollar index since the early 1970s has been more or less flat, offering a reminder that it’s best to assume that the expected return for forex through time is generally zero.
