The pros and cons of currency hedging

The currency conundrum continues.

With the dollar maintaining its strength versus other currencies, the question of whether to hedge that currency effect remains an important one for U.S. investors considering international exposures.

Although a strong dollar benefits U.S. tourists going abroad, for investors it can take a bite out of returns. Since returns in non-U.S. investments occur in local currencies, those returns may be reduced when translated into dollars in periods when the dollar is strong.  If the dollar weakens, the opposite is of course true, and it can boost international returns.

Indeed, 2018 underscored why currency exposure matters in international investing, as the dollar was broadly stronger against both emerging market and developed market currencies. The Currency Hedged MSCI ACWI Index outperformed the MSCI ACWI Index by 3.5 percentage points.

In 2019, the dollar has continued to rally (figure 1). U.S. economic growth has outpaced the majority of major developed markets, which manifests in higher interest rates, and in turn, higher “carry” – or income from interest rate differentials–for dollar investors. In emerging markets, worries over escalating trade tensions have also prompted a risk-off move out of many EM currencies and into the U.S. dollar. All of this has led to a stronger dollar versus most currencies.

All else equal, the Federal Reserve’s dovish pivot should reduce demand for the U.S. dollar, as it theoretically would lower short-term interest rates – the source of the dollar’s attractive carry. However, many major global central banks have also taken a more dovish monetary policy stance –some more aggressively easing than their U.S. counterpart. Additionally, the balance of geopolitical risks continues increased uncertainty in Europe, Latin America, and Asia. As a result, the dollar has remained strong since the Fed announced its shift in policy.

This underscores how currencies are difficult to forecast given their complicated sensitivities to economics, geopolitical frictions, and broader market expectations. For many investors, taking currency risk is not a rewarded factor boosting returns over the medium to long-term, as noted in by my colleagues in the BlackRock Investment Institute. Instead, for most, long-term investors currencies are more of a portfolio risk to manage.

Still, undertaking a hedged currency position does offer the advantage of mitigating the foreign exchange risk from an international investment, and essentially seeking to obtain more exposure to just the equity market performance.  For example, this year in the United Kingdom, the increased risk of a hard Brexit has weakened the pound, but a relatively strong underlying economy has kept the equity market relatively buoyed.  This has translated to a 6.7 percentage point out-performance of the Currency Hedged MSCI United Kingdom Index year-to-date over the un-hedged MSCI United Kingdom Index (figure 2).  The conundrum, of course, is knowing when to deploy the currency hedged strategy.

In some cases, maintaining an unhedged currency exposure can provide diversification benefits, particularly when a country’s equities and currency have moved in opposite directions historically, also known as the negative equity-FX correlation. In such cases, the relationship between the two assets can provide potential diversification benefits.

In short, investors looking abroad should consider the impact of currencies in the international portion of their investment portfolios across both stocks and bonds. With the rise of currency-hedged ETFs, investors now have the tools to express their view.

Related iShares funds

HEEM–iShares Currency Hedged MSCI Emerging Markets ETF

HEFA–iShares Currency Hedged MSCI EAFE ETF

HEZU–iShares Currency Hedged MSCI Eurozone ETF

HAWX — iShares Currency Hedged MSCI ACWI ex U.S. ETF

Chris Dhanraj is the Head of the iShares Investment Strategy team and a regular contributor to The Blog.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Index performance is for illustrative purposes only.  Index performance does not reflect any management fees, transaction costs or expenses. Indexes are un-managed and one cannot invest directly in an index. Past performance does not guarantee future results.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may under-perform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.

The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counter-party risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited.  There can be no assurance that the Fund’s hedging transactions will be effective. A fund’s use of derivatives may reduce a fund’s returns and/or increase volatility and subject the fund to counter-party risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited.  There can be no assurance that any fund’s hedging transactions will be effective.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This post contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by MSCI Inc., nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with MSCI Inc.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

©2019 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

ICRMH0819U-933948-1/1