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Should long-term investors in international equities use currency hedges?
Probably not… at least as long as their performance isn’t being measured in terms of quarters or even a few years.
That’s because over longer periods currency hedges reduce performance without reducing risk that much, according to research by London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton, writing in the latest annual Credit Suisse Global Investment Returns Yearbook.
They found that looking at 19 major markets in the 40 years to the end of 2011, average annualized unhedged equity returns came in at 6.1% against 4.7% for hedged equities for U.S.-based investors. There was a similar decline in returns to bond investors, 4.6% versus 3.1% for hedged portfolios.
But where hedging makes sense for bond investors because it considerably lowers risk, hedging offers only modest risk reduction for equities.
That, though, is only over the relatively short-term. The reduction of return volatility falls fast over time to where by eight years it offers little benefit or even has negative effects for both equity and bond investors in most cases.
Why?
Well, it’s because over the medium term, over a few years in other words, exchange rates tend to return to purchasing power parity. Most of this involves adjustment to differing inflation rates, although some also comes from relative changes in productivity.
Currencies may be irrelevant as far as hedging goes, at least over longer terms, but they can offer buying signals for equity investors. Currencies that have been weakest for the previous five years tend to be associated with the strongest subsequent equity market performance. And, in the case of emerging markets over the past 40 years, that outperformance has been considerable.
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