By: Larry MacDonald

The recent decline in the U.S. dollar again puts the spotlight on whether or not investors need to hedge currency exposure when investing in foreign markets. Are the costs worth bearing? I’d like to pass on some additional thoughts to a post I did a little while ago.

A number of empirical studies have looked at this issue. From their backtests of hedged/unhedged globally diversified portfolios, they have found that hedging was unnecessary for long-term investors. Two examples of the studies, covering the 1975 to 2003 period, are the Thomas paper, ‘Currency Risks in International Equity Portfolios’ and the Statman and Fisher paper, ‘Hedging Currencies with Hindsight and Regret.’

If currency hedging is unnecessary for long-term investors, that would seem to be good news. It would spare them the costs of hedging. And this cost can be noteworthy for those people buying foreign exchange-traded funds (ETFs) that include currency hedging. Costs take the form of higher MERs and tracking errors.

Yet, one risk with the unhedged view is the “fat tail.” Most of the time, as recent history points out, currencies will tend to fluctuate in ways that average out. But once in a while, a currency may collapse or go into a long-term decline against others. Latin American currencies suffered this fate in the past.

The U.S. dollar may well avoid such a fate given its central role in the world economy. But many articles and books nonetheless have been written warning that accumulating financial and trade imbalances could some day result in a currency crisis or flight from the U.S. dollar.

U.S. investors in foreign assets would thus seem to have even less need to hedge than what the empirical studies suggest – at least if they are long-term investors. True, the U.S. dollar could rise as the fiscal deficit widens and pushes up interest rates. This is what happened under Reaganomics in the 1980s. But that appreciation lasted only a few years.

Foreign investors in U.S. assets may see currency hedging as worthwhile – especially if they have a high level of risk aversion based on “fat tail” outcomes. They may end up with a lower net return than an unhedged investor if the fat tail does not occur, but that would be acceptable as the premium on an insurance policy. Investing choices should, after all, be made on a risk-adjusted basis. Currency hedgers may want, however, to find the lowest cost way of hedging as opposed to convenient choices such as currency-hedged ETFs.