In 2014, the US dollar appreciated about 10% against a basket of developed markets currencies. It appreciated by 12% vs. the euro and Japanese yen and 6% vs. the pound Sterling. This strong performance reduced the returns of unhedged international investments held by US investors.
In the first quarter of 2015, the US dollar continued to gain relative to major world currencies. In US dollar terms, the lower returns of unhedged international equities have prompted some investors to ask about the merits of hedging currency exposure within the international equity component of their portfolio. When the dollar strengthens, currency exposure has a negative impact on returns for US investors in unhedged international investments. When the dollar weakens, or depreciates, this impact is positive. The level of recent currency volatility is not unusual.
From 1974–2014, annualized currency returns relative to a basket of developed markets currencies exceeded 10% in absolute value in 11 out of 41 years. Currency returns have also swung from positive to negative and currency returns were positive about half the time (22 out of 41 years).
Some investors may want to hedge currencies because they expect the dollar to strengthen relative to other currencies. However, academic evidence suggests that currency movements are very difficult to predict in the short- to medium-term in a manner that is relevant for making investment decisions. In global equities, hedging foreign currencies tends not to reduce return volatility by a significant amount.
Equities are more volatile than currencies, so the volatility of an unhedged global equity portfolio is, on average, dominated by the volatility of the underlying equities, not the currency movements. As a result, unhedged and hedged equity portfolios have similar standard deviations.
In global fixed income, hedging currencies is an effective way to reduce return volatility because currency returns are more volatile than investment grade fixed income returns. So, if the currency exposure is unhedged, the currency will dominate the volatility in a fixed income portfolio. This is why unhedged fixed income returns typically have greater standard deviations than hedged fixed income returns.