Should You Hedge Currency Risk?
Currency prices go up, they go down, and sometimes they crash. And just like other financial markets, currency prices are not immune to volatility. Should you be hedging your portfolio against currency volatility?
The first argument in favor of currency hedged investments is that chaos happens. It can occur at any time in any place and although there’s sometimes clues, nobody knows when it will exactly strike.
Argentina, China (NYSEARCA:CYB), and Venezuela are recent examples of nations that have suffered severe economic setbacks because of falling currencies. Although these countries may seem like far-away places that don’t personally impact your finances, there’s a valuable lesson to be learned. What is it? Currency weakness and worse yet devaluation, can occur at any moment to any nation, including countries that appear to have the semblances of economic stability.
Hedging Works (Sometimes)
In my latest weekly podcast, I talk about how currency hedged ETFs offer a convenient mechanism for investing in securities abroad minus foreign currency exposure. For instance, the WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) provides exposure to Japanese stocks, but hedges currency exposure fluctuations between the U.S. dollar and the yen. If the yen is weak relative to the U.S. dollar and Japanese stocks are simultaneously increasing in value, DXJ would likely outperform Japanese stock funds that don’t hedge yen exposure like the iShares MSCI Japan ETF (NYSEARCA:EWJ).
Despite the many theoretical benefits of currency hedging, there will be times when these strategies underperform relative to unhedged strategies. Luckily for currency hedging bulls, this hasn’t been the recent case in many global markets.
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The chart below compares the WisdomTree Europe Hedged Equity Fund (NYSEARCA:HEDJ) versus the “unhedged” currency Vanguard Europe ETF (NYSEARCA:VGK). As the chart shows, the two-year performance of HEDJ has been around 15% better compared to VGK. This two-year outperformance has been largely due to the weak relative performance of the euro (NYSEARCA:FXE) against the U.S. dollar.
How to Properly Hedge
It’s important to remember that funds and ETFs that hedge currency exposure are higher risk and tactical funds that carry higher fees compared to traditional unhedged equity funds.
More importantly, the proper and only place for owning currency hedged funds – if you’re going to own them – is within the limited context of your non-core investment portfolio. As I teach in my online course, Build, Grow, and Protect Your Money: A Step-by-Step Guide, the non-core part of your portfolio always owns non-core assets, which currency hedged ETFs are.
When investors take a non-core asset like currency hedged ETFs and use them as core building blocks within their portfolio, trouble usually follows. Why? Because it increases your financial risk and forces currency hedged funds to perform a function they weren’t designed for. It’s far better to avoid these headaches by using currency hedged strategies exclusively inside your non-core portfolio.