The Currency Hedging Dilemma
Currency hedging comes with some trade-offs.
Currency hedging mitigates the additional volatility that exchange rates impose on foreign assets. But these currency-hedged strategies bear additional costs and can have tax implications. Our recent research paper, "The Currency-Hedging Dilemma,"addresses these various considerations. It reviews the fundamentals of currency hedging, explores the extra costs, and outlines a framework that investors can use to aid in their decision to choose a currency hedged fund.
The Nature of Currency Risk
When investors purchase a foreign investment, they must first convert their home currency to foreign currency. Thus, after completing a transaction, they are exposed not only to the risks of the foreign asset, but also to changes in the value of the foreign currency. This increases overall risk, and these two risks aren’t simply additive.
The relationship between exchange rates and local market returns plays an important role in the behavior of foreign assets. Most of the time, currency movements and returns are positively correlated, so currency risk usually adds to volatility. For example, the exchange rate between the U.S. dollar and British pound had a positive correlation with the MSCI United Kingdom Index denominated in pounds over the 10-year period through December 2017. Thus, the volatility of this index denominated in dollars was higher compared with the index denominated in pounds. The opposite scenario is less typical but has played out in Japan over this period. The correlation between the MSCI Japan Index denominated in yen had a negative correlation with the dollar-yen exchange rate. Therefore, the returns of Japanese stocks in dollars were less volatile than those denominated in yen.
How Hedging Works
Most currency-hedged funds use forward contracts to hedge currency risk. These contracts simply lock in a future exchange rate, and thus eliminate any uncertainty regarding where the currency of interest will trade in the future.
Prior to entering a forward contract, the two parties on each side of the hedge must agree on a forward (future) exchange rate. Three components determine what this forward exchange rate will be: the interest rate in the investor’s home market, the interest rate in the foreign market, and the current spot exchange rate between the two. These three inputs are related to the forward rate through a theory called covered interest-rate parity.
Table 2 shows the standard deviation, or risk, of foreign stocks and bonds denominated in dollars, and those same assets hedged back to the dollar with forward contracts. In all instances, the volatility of the hedged asset was lower than the unhedged asset.
Table 2 also shows that the volatility caused by currency fluctuations is relatively similar across foreign stock and bond indexes, with small differences stemming from different currency exposures in each index. But bonds are less volatile than stocks on an absolute basis. Therefore, hedging currency risk from bonds leads to a greater reduction in total volatility as compared with stocks.
The Costs Involved
Currency hedging has three major associated costs. First, the expense ratios associated with hedged funds typically (but not always) run higher than low-cost, cap-weighted alternatives. The second cost is derived from the hedge return, which is based on the interest rate difference across two economies. The third component of costs is associated with taxes, and therefore only applies to those using currency-hedged strategies in taxable accounts.
Expense ratios are the most explicit cost associated with an investment. In the context of currency hedged funds, expenses for funds that are diversified across a range of countries, currencies, sectors, and stocks are higher than the low-cost alternatives. Table 3 shows a 0.35% expense ratio for funds that track the MSCI EAFE 100% Hedged to USD Index, while comparable funds that track large-cap developed-markets stocks without hedging can be had for as little as 0.06%.
The forward rate used to hedge currency risk is determined by a difference in interest rates. But the rate difference across two economies also imparts an additional return to hedged strategies. This hedge return can be negative and can lead to a cost. It is less noticeable than a fund’s expense ratio and occurs when foreign interest rates are higher than those in an investor’s home market. When foreign interest rates are lower than those in the home market, the hedge return is positive and compensates investors. As an example, A U.S- based investor hedging their foreign exchange risk saw a positive return from hedging their euro, yen, or pound sterling exposure in May 2018 because interest rates in these markets were lower than in the U.S. But a negative hedge return (or cost) was incurred when hedging emerging-markets currencies because of their relatively higher interest rates. Overall, the cost of hedging currency risk should be low for developed markets as interest rates across these economies are relatively close to one another. The cost increases in emerging markets because these economies have relatively higher interest rates.
Hedging currency risk also carries tax consequences for investors that use hedged strategies in a taxable account. Currency-hedged funds roll their forward contracts on a monthly basis, so profitable contracts will generate capital gains. These gains are taxed in a different way than ordinary capital gains, and investors won’t get the lower long-term rate. Instead, 60% of the gains are taxed at the long-term rate, and the remaining 40% are subject to short-term rates. The distributions from these funds can be sizable. Table 5 shows the capital-gain distribution from these funds as a percentage of net asset value for 2015, 2016, and 2017.
Funds that hedge their currency risk can be an effective long-term strategy, so long as investors are aware of the expected benefits (lower volatility) and additional costs involved. Our paper takes a deeper dive into each of the areas mentioned above and presents a series of questions investors should consider when deciding to invest in a currency-hedged fund. It also discusses the current menu of currency-hedged fundsand provides guidance on alternative strategies such as partially hedged and dynamically hedged strategies. It’s worth noting that our Morningstar Analyst Ratings are indifferent to currency hedging. We assign the same rating to equivalent hedged and unhedged funds. Our neutral view stems from the expectation that hedging won’t act as a long-term performance enhancer, that the primary benefit of (some) of these strategies is long-term risk reduction, and that the decision to hedge or not to hedge is very case- and context-specific.
 United States Internal Revenue Service. 2017. "Gains and Losses From Section 1256 Contracts and Straddles." https://www.irs.gov/pub/irs-pdf/f6781.pdf
Daniel Sotiroff has a position in the following securities mentioned above: VEA. Find out about Morningstar’s editorial policies.