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.
The reason for the lower volatility in dollar-hedged strategies is straightforward: When equity markets decline significantly, investors often flee to high quality assets, and the dollar is one of these “safe havens.” In fact, since 1987 the MSCI EAFE USD-Hedged Index had a 77% downside capture ratio compared with the MSCI EAFE Unhedged Index.
Adding hedged equity exposure
After a very strong run in U.S. equity markets since the financial crisis, many investors are rebalancing into more attractively valued equities outside the U.S. We think the recent rally in the U.S. dollar serves as a useful reminder that currency movements affect the performance of international equity strategies. Allocating a portion of international equity investments to dollar-hedged strategies could provide both valuable diversification and the potential for downside protection.
For more on the U.S. dollar and the global economy, please see our latest Secular Outlook.
Andrew Pyne is an equity strategist and a contributor to the PIMCO Blog.