Currency risk is an often overlooked aspect of international investing that can significantly impact investors' portfolios. In this article, we will dive deep into the world of currency hedging and explore its importance in achieving the best possible returns when investing globally. Using insights from the MSCI World Index, we will discuss why taking currency risk should be a conscious investment decision and how currency hedging can serve as a tactical endeavor or a long-term investment strategy.The Dilemma of Currency Exposure When investing internationally, investors must deal with two sources of return: local asset return and foreign exchange (FX) rate fluctuations. This can be problematic during periods of foreign currency depreciation, causing underperformance. Although the default allocation for most investors combines equity and currency exposure, it is possible to uncouple those risks.Currency risk significantly affects the performance of a globally diversified equity portfolio like the MSCI World. For example, the MSCI World (unhedged) performance differs for US dollar-based investors compared to those with the Australian dollar as their base currency. The currency exposure differences can lead to notable performance disparities and increased risk in the portfolio.Making the Conscious Decision Currency risk sits on top of equity risk when investing in global equities, which means that deciding to take or not take currency risk should be a deliberate choice. Several factors influence FX rates, such as interest rate expectations, inflation differentials, public policy, growth forecasts, and balance of payments. Over the short to medium term, these factors can cause substantial currency fluctuations, leading to potential gains or losses for investors in unhedged foreign equities.Tactical Currency Hedging Investors with strong conviction about the direction of foreign currencies relative to their domestic currency can tactically hedge their portfolio to benefit from these movements. However, such tactical hedging requires expertise, and making the wrong call can lead to significant losses.Long-term Currency Hedging: A "Free Lunch"? Over the long term, currencies tend to fluctuate around a long-term equilibrium, meaning that the performance of currency-hedged and unhedged investments should be similar. However, the long-term volatility of unhedged investments tends to be higher. A reduction in risk with zero long-term expected returns might sound like a "free lunch," which is why investors could consider currency-hedged investments in foreign equities as their default long-term investment policy.The Operational Challenge Currency hedging can be operationally cumbersome, especially for portfolios with multiple currencies. The MSCI World comprises 13 currencies, which means investors would need to trade 12 FX forwards every time they want to hedge the currency exposure and then roll those 12 forwards regularly. This is where firms like Vanguard and iShares come into play, offering currency-hedged share classes for their strategies, providing turnkey solutions for investors and their currency-hedging needs.Conclusion Currency hedging is an essential aspect of investing in global equities. Whether you choose to use tactical currency hedging or opt for a long-term investment strategy, understanding currency risk and making informed decisions can help protect your portfolio from volatility and enhance your returns.
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