Currency Hedging – Why I Am Not Doing It
Currency Hedging? As I am an international investor, I often get the question on how to hedge for currencies. Many worry that, let’s say you invest in an European company at 100 EUR per share, the stock doubles but the EUR falls 40% in relation to the dollar. If we started with $1 equaling 1 EUR, the stock is now at 200 EUR but one dollar is now at 1.66 EUR, so your gain in EUR is 100% buy your gain in dollars is just 20.4%.
Here is the video, article continues below.
So, if you are holding foreign assets, you are exposed not only to the volatility of the stock, but also to the volatility of the currency. How to hedge and is it necessary are the questions? This article will give you the answers and you will see what is the best strategy for you.
I’ll first explain how one can hedge for currency fluctuation and then discuss the rationale behind it so that you can see for yourself whether hedging is something you wish to apply to your portfolios or not.
4 Currency hedging strategies
Ok, let’s say you are a US investor and hold the European stock we mentioned above. In order to hedge yourself for currency fluctuations you would have to lock in future exchange rates.
If you are long a European stock, you should be short the European currency for the same amount. In that way, if the EUR goes down, your short position covers for the currency loss.
But, if the EUR strengthens, you don’t gain on that because your short position loses money.
You can hedge yourself in various ways:
- You can use ETFs that short the respective currency against your currency
However, you have to understand that this is only for daily trading and the ETF is actually structured to go to zero at some point.
Source: ProShares
Plus, there is an expense ratio of 0.95%. Thus, on top of the potential losses in day to day currency movements, you pay 0.95% in expenses. Such daily ETF vehicles are very complex and my opinion is that those are just invented to cater for those that want to look smart, but that is just my opinion.
- Using hedging contracts for difference
With a contract for difference you agree to pay or get the difference in the currency pair over a specific period of time. These are again complex structures and actually banned in the US.
- Hedging currency risk with forward contracts
A forward exchange contract, a derivative, allows you to lock in an exchange rate now for a predetermined date in the future. These contracts last for a month to longer so you have to roll-them over constantly. The exchange rate is calculated by discounting the interest rate differentials.
- Using options to hedge your currency exposure
Options give you the right but not the obligation to exchange currencies at a predetermined date and exchange rate. You can buy those and be hedged at a fixed cost or you can sell options and then be exposed to whatever happens.
So, now you know how to hedge, right?
Of course not! All the above are complex instruments that require lots of work and come alongside high costs. I firmly believe investing is about keeping things simple. When people start complicating things, run away.
Is there a benefit to hedging currencies at all?
Firstly, by hedging you protect yourself from currency volatility and you pay a cost for that. However, currency volatility can be both a benefit and a loss for you. By hedging you eliminate both positive and negative risks. By not hedging you eliminate all the costs related to it, which is a big positive and currencies eventually even out.
Research is pretty clear on currency hedging: don’t do it.
The Credit Suisse 2012 yearbook has a big part of it dedicated to currencies.
If you focus on the short term you are not an investor, and that is the only place you can use hedging with a benefit to smooth out your returns.
Source: Credit Suisse
They have given us the numbers to show what hedging and no hedging means.
Source: Credit Suisse
Source: Credit Suisse
Similar for Intenrational investors, not a big difference. What you buy matters, not the currency or the hedges.
Ken Fisher and Meir Statman have
So, if you are an investor, over the long-term, sometimes you will win, sometimes you will lose. However, there is a benefit when it comes to currencies, which is diversification.
Currency diversification
Currencies always ebb and flow in relation to the inflation, expected inflation or interest rates in a country. The US dollar index shows how the dollar is sometimes strong, sometimes weak.
Source: FRED
Unfortunately, there are so many factors influencing currency that nobody can know whether the dollar will strengthen further or fall over the next years. If you are globally diversified, you might take advantage the time when your currency is strong and buy assets where the currency is temporarily weak. A lot of currencies move with the cyclicality of their markets and economies.
However, I firmly believe currencies are a minor issue. We as investors, should only invest in assets. When you buy a good assets, no matter where it is, currency doesn’t really mean much. Plus, most companies are global companies with diversified income streams. For example, Russian gas producer Gazprom, that was just upgraded by Morgan Stanley now that the stock is up 100%, has costs mostly in rubbles, but revenues is both rubbles and US dollars. So, if the rubble weakens, the company makes more money from exports, if the rubble strengthens, Gazprom makes more money on the local market from a foreign investment perspective.
Source: Morgan Stanley
My main message is to focus on businesses. If there is inflation that impacts a currency over the long-term, you need to own businesses that have pricing power over that, that have value no matter where those are.
Source: Credit Suisse
So, it always boils down to value investing. You find a good business, that will do well long-term, you find it at a fair price, possibly with a margin of safety and then you don’t have to worry about anything. That is what I do, I look across the globe for the best global investments, when I find those, the impact of currencies is minimal and therefore I don’t need to think about complex and costly hedging.
The Swiss Investor – Extreme Case
Just for fun, let’s discuss a Swiss Investor – the Swiss Frank appreciated against all currencies over the last 30 years, especially from 2001 to 2011. However, since 1991, it appreciated just 20% against the dollar. 20% over almost 30 years is a difference of just a bit more than 0.5% in yearly returns.
Source: Macrotrends
Even the 45% difference from 2001 till now is still just a bit above 2% on a yearly basis. That is the difference between a PE ratio of 10 and 8. The Swiss cape ratio is 26, and any CAPE ratio lower than 17 would offset a 2% yearly difference in returns if the Frank continues to appreciate.
Source: Starcapital
BUY BUSINESSES
So, my message is again that the best is to focus on businesses, buying a better business wherever it is, will surely give you a larger difference than 0.5% per year, even 5% per year, and that is something no currency can match.
Forget about currency, focus on owning wonderful businesses that offer value, pricing power and a margin of safety.