In a reversal from last year, the U.S. dollar has strengthened against other major currencies in 2018, reflecting rising U.S. rates, expectations of more Federal Reserve rate hikes and recent sluggish economic data outside the U.S. While U.S. dollar strength has broad implications for earnings and markets, it also has a direct impact on the performance of international equity allocations for U.S. investors. Most international equity strategies are unhedged, which generally benefits U.S. investors in periods of dollar weakness but creates a headwind for returns when the dollar is strengthening.
So the dollar’s recent reversal raises an important question: Should investors start to incorporate currency hedging into their international equity allocations?
Unhedged versus hedged
Traditional active equity managers often say that their edge is not in forecasting currencies but in stock picking, and currency exposures are a fallout from the stock selection process. How then can investors in international equities incorporate currency hedging into their allocation?
International equities are a strategic investment for most, and attempting to tactically time exposure to the dollar seems inconsistent with a long-term horizon. Indeed, given transaction costs and the difficulty in forecasting currency movements, we would advise against such timing.
However, investors may want to consider a strategic allocation to a U.S. dollar-hedged international equity strategy. A hedged strategy can offer two important long-term benefits. First, when combined with an unhedged equity strategy, a hedged strategy can provide diversification: Hedged portfolios generally benefit from dollar strength and face a headwind in periods of dollar weakness. Second, hedged strategies have historically provided lower volatility and higher risk-adjusted returns, as represented by the index in the chart shown below.