Before choosing a currency-hedged foreign-stock fund, it's important to understand the mechanics of hedging and the various outcomes that can occur.
One of the drawbacks that comes with investing in foreign stocks is their higher volatility relative to domestic stocks. From January 2000 through June 2017, a U.S.-based investor holding a fund that simply tracked the MSCI United Kingdom Index weathered a standard deviation of 16.8%. That investor's counterpart in London, who owned shares in a similar fund, tracking the same index, experienced a standard deviation of only 13.8% during the same period. Same index, but different volatility? There's some nuance here. The U.S. and U.K. indexes are not exactly the same. The former is denominated in dollars, the latter in pounds. And the source of the extra volatility borne by the U.S. investor was a direct result of fluctuating foreign exchange rates.
Foreign exchange rates are hardly static. Their fluctuations will--in most cases--increase the volatility of a U.S. investor's foreign stock portfolio. Exchange rates also tend to be cyclical and have little impact on long-term rates of return. Thus, over a long horizon, investors should assume that they won't be compensated for assuming currency risk.
This may sound troubling. Why take this risk if you're not going to earn anything in return? But not to fear, fund providers have come up with a solution: funds that hedge or eliminate this additional currency risk. But before choosing to pursue a currency-hedged fund, it's important to understand the mechanics of this activity and the various outcomes that can occur. Currency-hedged funds also have additional costs associated with them, which can make them more expensive than those that are unhedged.
The Mechanics of Foreign Exchange Volatility
Exhibit 1 summarizes the volatility of foreign stocks from several regions denominated in their local currency and U.S. dollars. Indeed, there is ample evidence to support the idea that the returns of foreign stocks are more volatile when converted to U.S. dollars. The exception to this rule has been stocks listed in Japan, which were actually less volatile in dollars than yen.
Japanese stocks present an interesting and wonderful example when it comes to understanding how foreign exchange rates impact the volatility of foreign stocks. Effectively what is taking place here is the summation of the standard deviation of two signals. In this case the signals of interest are foreign stock returns denominated in local currency and a foreign exchange rate. The following equation relates the standard deviation of foreign stock returns in U.S. dollars (SUSD) to the standard deviation of foreign stock returns in local currency (SLCL) and a foreign exchange rate (FX).
This formula may look intimidating, but it essentially boils down to three components:
The third item, the correlation or relationship between the prior two, is less obvious but no less important. I'll illustrate this with a few hypothetical scenarios. First, let's assume that foreign stock returns in local currency have a volatility of 20%, and the exchange rate has a volatility of 10%. Now, let's keep these two values fixed and then alter the correlation, or the relationship between the other two variables. In the table below, I've plugged in three different values for the correlation coefficient: a value of 1 to illustrate a scenario in which stocks in local currency and exchange rates move in lock step, a value of 0 to represent a case where they have no relationship, and a value of negative 1 to reflect an instance where they move in opposite directions.