Currency Hedging and Strategic Moves: Enhancing Model Portfolios

In this case, currency and its effect on your underlying allocations and investment choices.

The foreign exchange (FOREX) markets and how different currencies interact with each other can throw a model out of whack. The flipside is that currency changes can be a powerful tool for gains. And with more investors understanding the value of international investing, currency and its movements must be included in a success model plan.

When most investors think of the FOREX markets, they do so from the idea of risk assets: the concept of the 24-hour trader buying and selling various currency pairs in order to score big trades. Although, that world does exist. But even the most conservative investors experience currency trading and fluctuations in their portfolios — including those looking to execute on a model portfolio. Every asset class is exposed to currency and its changes.

The exposure comes in two ways. Every portfolio has a base currency or the currency that the holdings are priced in. For U.S. investors, it’s the dollar. If you live in Japan, it’s the yen, and so forth. Where it gets trickier is in the underlying asset classes.

Model portfolios and the creation of ETFs have made international investing an easy proposition for investors. With one or two tickers, you can instantly add global assets to a portfolio. There are numerous reasons to consider adding global stocks or bonds to a model portfolio — greater diversification, higher potential income and an overall larger opportunity for success are just a few. The issue is when you buy a fund such as the * iShares MSCI EAFE ETF* or SPDR Portfolio Emerging Markets ETF to get that exposure. These assets are priced in your base currency — in this case, the greenback. However, the underlying stocks are priced in Yens, Euros, Francs, Hong Kong dollars, etc.

The issue arises when translating those differences. On the one hand, the individual stocks and the index returns are represented in their local currencies. On the other hand, one needs to consider how the underlying currencies perform relative to the U.S. dollar. This can have a dramatic effect on total returns. And even if a stock in its local currency surges, a rising U.S. dollar can crimp those gains and, in some cases, turn them into losses.

For example, looking at Morningstar data we can see those differences in action. Looking at the MSCI EAFE Index and its local currency and U.S. dollar returns, we see that the yearly returns difference has been as much as 27 percentage points. This chart from the researcher underscores the swings. ¹

Source: Morningstar

Many investors and model builders might see this and say, “I’ll just skip going global to avoid currency effects.” However, even investors aren’t immune from FOREX and its influences. A firm like Coca-Cola or Apple sells the same amount of soft drinks and smartphones overseas as they do in the U.S. Translating those local currency revenues into dollars also exposes them to currency fluctuations.

For investors building a model portfolio, currency, and its changes are factors that can’t be ignored. Currencies over the short term can have significant fluctuations and change the overall return of international assets and international sales-focused U.S. firms. All in all, it could be a smart move to think about including this factor when building out a model portfolio.

And there are 3 ways to go about planning for this.

The first is the simplest and that’s via hedging. Hedging uses derivatives to get the local return and paying or receiving the interest rate differential between the base currency and foreign currency. By hedging all or some of their currency risk, investors essentially get the “real return” of an asset. And doing this can provide higher overall returns. According to asset manager Avantis and Bloomberg, investing $1 into MSCI World Index Hedged USD Index would provide slightly more return ($4.35) than its non-hedged counterpart ($4.25) over twenty years. ²

The second way is to be strategic with currency and to position for risks and opportunities. This would involve moving a portion of a model into and out of various currencies to take advantage of local trends and changes. For example, strong oil prices tend to boost the currency of commodity-rich nations like Canada. However, this probably involves more trading than many investors using a model portfolio want to do.

The third option is to consider currency as an asset class in a multi-asset model portfolio. Liquid alternatives, or alts, have emerged as uncorrelated asset classes and as a way to get diversification benefits. Currency doesn’t play like other asset classes and is used to generate additional and uncorrelated returns. Thinking this way, the currency effects on a portfolio are mitigated because you’re actually isolating it to another portion of your portfolio. The changes and effects can produce a source of returns in a separate sleeve, reducing risk and balancing out your international exposure.

The win is that model portfolios and investors still have an opportunity to face currency risks head-on with outspending a pretty penny and keeping with the simplistic point of view. Just like many other sectors, ETFs have made currency and hedging a low-cost proposition. There are now numerous ETFs that hedge or bet directly on currency futures to provide exposure to asset classes or the underlying currencies themselves.

Investors can add these ETFs to their model portfolios to explore any of the ways to mitigate currency effects and potentially generate better long-term returns. The key is what avenue to take and what exposure to do.

These funds were selected based on their direct exposure to currency or their ability to use currency to hedge their indexes. They are sorted by their YTD total return, which ranges from -2% to 20%. They have expenses between 0.20% and 0.70% and assets under management between $58M and $6.65B. They are currently yielding between 0% and 6.2%.

Overall, currency and its fluctuations shouldn’t be taken lightly by investors. Returns can differ wildly depending upon its movements. For those model portfolios, understanding how currency fits into their portfolios and potentially hedging or exploiting it makes a lot of sense. It can form the basis of a dedicated asset class or a strategic hedge against its movements. Either way, currency should be a factor when building a model portfolio.

Many model portfolio users often forget about currency with regards to their allocations. However, they shouldn’t do that. Understanding how currency and its changes impact a portfolio is key. It’s here that investors can hedge against these risks or potentially use them to their advantage.

¹ Morningstar (September 2024). The Currency Exposure Dilemma in Foreign Investing

² Avantis (March 2024). Currency Effects on Non-U.S. Stock Returns