Lately, it seems like a world gone mad, with central banks from China and Japan to Western Europe dropping interest rates right and left, and currency speculation running rampant.
For the average investor, picking the right investment vehicles in the right sectors in the right countries is hard enough. But it is possible to get all that right and still see your returns eroded if the currency markets move against you, and these days such moves can be swift and dramatic.
At the end of January, Japan cut interest rates into negative territory, a surprise move that sent global equities sharply higher, only to see the markets reverse themselves over the following weeks.
The Japanese yen/U.S. dollar relationship has been volatile as well, with the yen rising 3 percent against the dollar as of mid-January and then climbing another 5 percent through the first nine days of February. This kind of volatility tends to make speculators out of investors, whether they want — or even mean — to be or not.
This increasing volatility explains, in part, the popularity of currency-hedged exchange-traded funds and other investment vehicles. For a U.S. investor, translating an investment from one currency to another can have a positive, negative or neutral impact on the returns of the underlying securities, depending on how the local market currency performs relative to the U.S. dollar over time.
All other things being equal, a stronger U.S. dollar will have a negative impact on non-U.S. investments, while a weaker dollar will be positive for returns. Either way, for a U.S. investor a portfolio that is 100 percent hedged — or 100 percent unhedged — has made an implicit call on the direction of the dollar.
A fully hedged portfolio has historically hurt returns when the U.S. dollar weakened, relative to international currencies , whereas an unhedged portfolio has historically underperformed when the dollar strengthened.
In the best of times, it's hard to predict currency movements — a difficulty that's compounded in a world in which central bank policies are rapidly diverging and countries are using currency devaluation to gain economic advantage.
The question of "to hedge or not to hedge" is no doubt a complicated one, as there are other knock-on effects to 100 percent on/off currency hedging strategies, and what works in one market may not work in another.
For example, while a fully hedged currency position is often assumed to help mitigate volatility, it can actually increase an investment's risk profile, depending on the specific dynamics of the underlying currencies.