By Jeremy Schwartz, CFA, Director of Research
How many people think it is a smart idea to take their exposure
to U.S. equities and layer on top of it-dollar for dollar-an
additional exposure to the U.S. dollar? This type of layering
additional risk might be called a form of leverage, as an investor
would be providing two sources of return for a given dollar
investment. For example, consider a $1 investment in a hypothetical
fund that provides exposure to $1 of U.S. equities and $1 of
exposure to the U.S. dollar ($2 of distinct asset class risk for
every $1 invested). Few long-only investors in the U.S. desire this
strategy, and I have rarely seen anything like this exposure
offered to investors in the U.S.
If few U.S. investors would leverage up their S&P 500
exposure with a secondary bet on the U.S. dollar, why should it
always make sense to layer on euro risk when buying European
equities or yen risk when buying Japanese equities?
When investors buy overseas assets, they have to sell U.S.
dollars and buy euros or yen to purchase those overseas stocks.
Unless a currency (foreign exchange, "FX") hedge is made to
mitigate this FX risk, investors are fully exposed to FX
Recently, currency-hedged equities have gained traction to
neutralize the FX risk and target the local stock market returns. I
have been talking to clients about currency-hedged strategies for
much of the last five years, and virtually all conversations start
like this: "Why should I hedge my currency risk?" But that is
perhaps the wrong starting point. A more natural starting point to
me is this: Why is it beneficial to add currency risk on top of
local equities? Let's go through common rationalizations.
One answer to why many take on the FX risk: a misperception that
it is expensive to hedge foreign currencies. This can be a valid
concern in some countries today: Brazil, India, South Africa and
Turkey, for example-all countries that have very high short- term
interest rates when measured against U.S. interest rates. I'd agree
the case to hedge these emerging market currencies is diminished,
as there is a higher hurdle for how much these currencies have to
depreciate for the hedge to pay off.
But the cost to hedge developed world currencies such as the
euro and the yen has been brought down to virtually zero because
all their interest rates are pegged near zero. Central bankers have
been guiding us to believe that the U.S. Federal Reserve will be
the first major central bank to increase short-term interest rates.
The European Central Bank and the Bank of Japan have set their
forward guidance to keep interest rates low for a long period-so it
is possible to collect some interest to hedge the euro and yen at
some point in 2015. This environment makes currency hedging
particularly relevant in the developed world today.
The next two arguments I hear for taking on currency risk:
- Currency provides diversification to my portfolio.
- U.S. dollar bears want protection from a falling U.S.
I am going to explore each premise in some detail here. I
believe one can make just as strong a case that the U.S. dollar
should appreciate versus at least half the most common exposure to
developed international currencies (the euro and yen).
But even if one is a U.S. dollar bear, I will provide an
additional question as to what the best equity investment would be
given a bearish U.S. dollar bias. Hint: It's close to home. I also
will discuss why the "diversification" argument also seems
unconvincing-or at least why the historical diversification foreign
currency provided to U.S. investors appears to be declining.
Reality Check For U.S. Dollar Bears
The historical three-year cumulative impact currency has had on
the MSCI EAFE Index for U.S. investors is charted below. This is
the additional exposure from FX an investor gets unless that FX
risk is hedged. One of the clear signs on this chart is that FX can
really enhance or drag down returns significantly. There was a
three-year period when the FX added 80% cumulatively to the returns
of the MSCI EAFE. But there also have been times when FX subtracted
more than 20% cumulatively on a three-year basis.
This additional return component has gone from a fairly large
booster in the late 2000s to a drag, with the most recent
three-year stretch as of July 31, 2014.
Where Does FX Go From Here?
One of the most important variables in exchange rates is
interest rate policy set by the central banks. Below are two
statements that come from the head of the Bank of Japan (BOJ) and
the European Central Bank (ECB).
Haruhiko Kuroda on August 8:
"A reversal of excessive yen rises has had a pretty big positive
impact on Japan's economy, such as a pick-up in corporate capital
spending. ... The Federal Reserve continues to taper its asset
purchases, while the BOJ and the ECB continue to maintain
ultra-loose policies. I don't think there is any reason for the yen
Mario Draghi on August 7:
"Fundamentals for a weaker exchange rate are today much better than
they were two or three months ago":
Monetary Policy Divergence:
"monetary policies in the euro area and in the United States are,
and are going to stay, on a diverging path for a long period of
"monetary policy announcements of last June have been successful.
They have been successful, not only the various monetary policy
announcements, but especially so the negative deposit rate"
"There has been a quite significant increase in the short
positions on the euro... Other central banks have been reducing
their exposure to the euro. And if you look at how markets are
expecting real rates to be for the foreseeable future, meaning
until 2019, current expectations are that real rates will remain
negative in the euro area for a much longer time than they will
be in the United States. I think that is one of the major
developments that I would pick up from what happened in the last
three, four months."
As the U.S. completes its quantitative easing (QE) program while
the Bank of Japan ramps up its program and the Europeans consider
more monetary policy actions, U.S. dollar bears need to face the
reality that the U.S. dollar may be strong for a considerable
period given shifting stances among central banks. A speech by
James Bullard, the president of the Federal Reserve Bank of St.
Louis, talked about the impacts of easier monetary policies such as
QE. Bullard suggested that the ECB should go down a similar route
as the Federal Reserve (Fed), because QE largely accomplished its
mission in the U.S. Bullard attributes QE to easier monetary
policies, which historically have resulted in, among other things,
currency depreciation. Euro weakness is part of the prescription
many suggest to help Europe reinvigorate its economy and spur some
QE effectiveness from Bullard:
"Traditional effects of "easier monetary policy" include (1) higher
inflation expectations (2) currency depreciation (3) higher equity
valuations (4) lower real interest rates. All of these have been
associated with QE in the U.S."
Going FX Neutral By Currency Hedging
Investors who take on FX risk must recognize that they are
implicitly expressing a bearish view of the U.S. dollar. Without a
hedge, an investor is implementing a tactically bearish view on the
U.S. dollar when holding foreign equities-but this does not have to
be the case. Currency-hedged options could allow an investor to be
neutral with no opinion on the direction of the U.S. dollar by just
targeting the local equity market return.
An investor who is bearish on the U.S. dollar can selectively
add in FX or other asset classes to capitalize on this view. Based
on historical correlation data, international stocks do not appear
to be the best positioned to capitalize on an FX rally or weak U.S.
One asset class that had been increasingly benefiting from a
fall in the U.S. dollar: the S&P 500 Index. Data shows the
S&P 500 has become strongly negatively correlated to its
currency and as strongly negatively correlated as it has been in 40
years. Some fund flow and asset class flow reasons are accentuating
these correlations, but there are also business and economic
reasons that explain this pattern.
Next to Japan, the S&P 500 is one of the strongest
negatively correlated markets to its currency. And the reasons may
be similar. A growing share of revenue and profits for U.S.
corporations comes from overseas-and that number seems only likely
to increase with globalization of the economy. Weakening of the
U.S. dollar supports revenue and earnings that come from overseas.
For a U.S. dollar bear, perhaps the best option is thus to invest
more in the S&P 500 and other multinationals in the U.S., along
with FX separately. As I will discuss later, when these foreign
currencies rose in value versus the U.S. dollar, their returns were
often not all that attractive.
What About Diversification?
Does FX provide a level of diversification not offered by the
local equity markets? If an investor had to decide to allocate to
EAFE FX as just a standalone investment, let's review the case.
- Over the history of the MSCI EAFE Index, EAFE FX has added
1.6% annually to the returns of the MSCI EAFE Index. This means
the U.S. dollar declined by 1.6% per year over this period.
- This return stream had an annualized volatility of 8.4% per
year, a little more than half the volatility of EAFE equities (in
- The correlation of EAFE FX to the S&P 500 over the full
40-year periods was fairly low-only 0.09. But note a very
important correlation trend: This EAFE FX correlation to the
S&P 500 has been rising consistently in recent periods. In
the last three years, the correlation between EAFE FX and the
S&P 500 was 0.64, so EAFE FX is not providing the same type
of diversification as it did historically.
More importantly, one has to wonder if the past gain in EAFE FX
can be repeated. We know with hindsight that the U.S. dollar
declined. But do we know the U.S. dollar will decline going
forward? Theoretical models suggest there is no expected return to
owning currency. So why does one want to take on this FX risk
embedded in foreign equity exposure unless one is a tactical U.S.
- The correlation to the S&P 500 for EAFE with FX and EAFE
with no FX shows practically no differentials over the last 3-,
5-, 10- and 20-year periods. There is a slightly lower
correlation to EAFE with FX over 40 years of data, but that does
not appear to be a compelling case to add currency exposure on
top of the local equity market return given the uptick in total
volatility from adding FX and the unpredictability of future
I thus struggle to understand the rationale to take on EAFE FX
risk given the volatility profile, the rising correlation to the
S&P 500, the lack of return expectations from FX investing and
the very low cost of hedging these currencies today.
The Declining Diversification Of Owning The Euro
On the next page are the same charts for the European FX
correlation to the S&P 500, which also show a consistent
increase and less diversification from holding euros on top of
owning the European equities.
- The European FX as a standalone asset class historically had
10% volatility consistently over most major periods- again, just
about half the volatility of the local equity market.
- The long-term returns to the MSCI EMU Index currencies were
only 0.1% per year-this means the risk-return trade-off for
European currencies as a standalone asset class showed relatively
miniscule historical returns with large volatility (a bad
- EMU FX over the long run had a correlation of 0.14 versus the
S&P 500, but that has risen significantly to 0.68 over the
last three- and five-year periods. This rising correlation means
there is less diversification benefit to owning the euro.
Do You Really Want To Own Yen With Japan Equities As A
The Japanese yen, evaluated on a standalone basis, looks like an
interesting asset class to diversify S&P 500 exposure, as the
yen displays a negative correlation to the S&P 500 over the 40
years of data and a sharper negative correlation in more recent
But does this mean one should take on the yen risk by packaging
it on top of Japan equities? Not necessarily, as the Japanese yen
is even more negatively correlated to Japanese stocks than it is to
the S&P 500, and Japanese stocks can thus take a bigger hit if
the yen rises.
The three-year correlation of the S&P 500 and the yen was
-0.33, but the three-year correlation of the yen and the MSCI Japan
Index (in yen) was -0.74. If one really wanted a hedge for a
bearish scenario in the U.S. equity markets, the historical
correlation data would suggest the yen could serve that choice as a
standalone investment, but not unless it's packaged with Japanese
equities. It's possible to see the yen rising during a time when
the U.S. economy slowed down significantly or China's economy had a
particularly bad stretch. That does not seem to be a time one would
want to own Japan's stocks.
The historical volatility profile of the yen and Japanese
equities also reveals an interesting characteristic. During the
period I call "the Abe period," I show how a strongly weakening
currency of almost 20% led to significant gains in the equity
markets-up almost 70%. This led to higher volatility for Japanese
stocks. But this was volatility that should be desired-stocks doing
well as the currency is declining. The fact that packaging the
equity risk and currency risk lowered volatility does not seem like
a desirable goal for international equities; rather, it is the
ultimate reason to own many of these foreign markets.
Japan Is Not A Unique Case
Japan's case study of having quite strong returns when its
currency was declining is not unique through history. Earlier I
discussed how the S&P 500 was showing a strong negative
correlation between the U.S. dollar and the S&P 500. Over
long-term periods, the MSCI EAFE Index performed better measured in
local currencies when the EAFE FX was declining and so did the MSCI
EMU Index. The MSCI EMU Index has a little less than 30 years of
data, but the differentials are striking-14.5% average annual
returns when currencies were declining versus just 1.4% average
annual returns when the EMU FX was rising. These points illustrate
that some of the best returns to foreign markets came when
currencies were declining and the U.S. dollar was rising - but one
must hedge the FX risk to achieve those returns.
Whereas many traditionally have thought that getting bullish on
the U.S. dollar should mean allocating less to foreign stocks to
avoid the FX hit, the reverse is actually true: One should increase
exposure to foreign stocks when the dollar is rallying, just in a
The discussion of currency-hedged strategies has shaken some of
the core beliefs of investors. Traditional investment vehicles that
package equity risk plus a secondary currency risk on top of the
equity risk have been referred to as the traditional "plain
vanilla" exposure because they were the first to the market, and it
is what investors have been using for so long.
But if one started with a clean slate, I believe one would say
that adding currency risk on top of the equity market is actually
more exotic than currency hedging. The example that started this
piece of the S&P 500 and U.S. dollar packaged together should
illustrate that case fairly clearly.
I believe it's necessary to take a harder look at the
diversification attained by adding in this FX risk. If investors
evaluated FX as a pure standalone investment instead of a package
product, I think they would rarely find themselves convinced of the
reason to add in this exposure to their portfolios. There has been
rising correlation to the S&P 500, low historical returns to
FX, high historical volatility and a tactical environment that
looks likely to favor the U.S. dollar.
Ask yourself this: Why am I taking FX risk in my international
portfolio? It is fairly easy now and rather inexpensive-especially
on a relative interest rate basis-to hedge developed world FX
exposure to currencies like the euro and the yen. I think more and
more U.S. investors will come to this view in the coming years.
Unless otherwise stated, data source is WisdomTree.
Investors should carefully consider the investment objectives,
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obtain a prospectus containing this and other important information
visit wisdomtree.com. Investors should read the prospectus
carefully before investing.
Diversification does not eliminate the risk of experiencing
investment losses. Foreign investing involves special risks, such
as risk of loss from currency fluctuation or political or economic
Investments focused in Japan are increasing the impact of events
and developments associated with the region, which can adversely
Investments focused in Europe are increasing the impact of
events and developments associated with the region, which can
adversely affect performance. You cannot invest directly in an
Investments in currency involve additional special risks, such
as credit risk and interest rate fluctuations.
S&P 500 Index: A market capitalization-weighted benchmark of
500 stocks selected by the Standard & Poor's Index Committee,
designed to represent the performance of the leading industries in
the United States economy. MSCI EAFE Index: A market cap-weighted
index composed of companies representative of the developed market
structure of developed countries in Europe, Australasia and Japan.
MSCI EMU Index: A free float-adjusted market
capitalization-weighted index designed to measure the performance
of the markets in the European Monetary Union. MSCI Japan Index: A
market cap-weighted subset of the MSCI EAFE Index that measures the
performance of the Japanese equity market.
WisdomTree Funds are distributed by ALPS Distributors, Inc.
Jeremy Schwartz is a registered representative of ALPS
© 2014 WisdomTree Investments, Inc. "WisdomTree" is a registered
mark of WisdomTree Investments, Inc.
Jeremy Schwartz, Director of Research
As WisdomTree's Director of Research, Jeremy Schwartz offers
timely ideas and timeless wisdom on a bi-monthly basis. Prior to
joining WisdomTree, Jeremy was Professor Jeremy Siegel's head
research assistant and helped with the research and writing of
Stocks for the Long Run and The Future for Investors. He is also
the co-author of the Financial Analysts Journal paper "What
Happened to the Original Stocks in the S&P 500?" and the Wall
Street Journal article "The Great American Bond Bubble."
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