A surging dollar aside, think risk first when it comes to currency exposure.
The U.S. dollar looks invincible these days (Exhibit 1). For U.S. investors, its surge can make the case for hedging foreign-currency exposure seem like a one-way argument. Why own other currencies? The dollar gained 17.4% against the euro, 13.6% against the yen, and 7.4% against the pound over the past year through Feb. 23.
Moreover, there are good reasons why the dollar may remain strong, at least over the short term. The U.S. Federal Reserve seems determined to raise rates at some point in 2015, which would be the first time it's done that since 2006. A rate increase would likely support the dollar, at least relative to the yen and euro. That's because both the Bank of Japan and the European Central Bank plan to keep monetary policy loose for the foreseeable future. Both central banks hope to stoke inflation as well as keep their currencies (the yen and euro) weak relative to the dollar in an effort to boost exports. In fact, a group of finance ministers and central bankers (representing the G-20 countries) recently admitted that currency depreciation was a goal of monetary policies like quantitative easing.
Nonetheless, while the current trends in currency markets seem strong, they won't last forever. As with equities and bonds, currencies also tend to come back to earth after periods of strength. This happens either through market corrections or by direct government intervention. Thirty years ago, the G-7 countries, faced with a similarly strong dollar, agreed to weaken the dollar through the Plaza Accord. These days, the United States seems willing to tolerate a strong dollar, but its stance could change if it starts hurting economic growth.
With this as a backdrop, it's easy to understand why many investors--especially those in the United States--are interested in strategies that fully hedge their foreign-currency exposure. Besides, it's hard to feel good about owning currencies that are being actively depreciated. But especially during times like this, it's worth taking a step back to revisit basic investing principles.
How to Think About Currency Exposure
As a starting point, no matter in which country they reside, investors shouldn't manage their currency exposure based on current conditions. Currency management demands the same sort of long-term thinking that applies to other strategic asset-allocation decisions.
That said, how to approach managing currency exposure isn't clear cut. (Indeed, given the global operations of many large-cap companies, it can be difficult to assess what one's true currency exposure even is.) Unfortunately, there's little consensus around whether currency exposure within an equity portfolio should be hedged or not. For U.S. investors, there have been long stretches of a decade or two in which hedging would have been advantageous--and vice versa--but it's nearly impossible to determine in advance which option will deliver higher returns.
Of course, there are no guarantees with equities or bonds either. Both equities (think Japan since 1989) and bonds (U.S. Treasuries from 1951 to 1981) have had similarly long dry spells. But at least an investor continues to receive dividends and interest payments. Although current valuations play a huge role in future returns, equities and bonds are designed to deliver a return over time. Even long-term U.S. Treasuries still delivered small gains (1.8% annualized) during their 30-year bear market. The same cannot be said for currencies, although some studies have found that the premium for foreign equities owes in part to currency risk. Currency returns are a zero-sum game. The gains are always in relation to the losses of another.