Should international equity returns be currency-hedged?

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AcadiFi · Accepted Answer

**The decomposition**: Unhedged international equity return ≈ local return + currency return + interaction term. Currency can add or subtract 3–8 percentage points of annualized volatility.

**Arguments for hedging (to base currency)**:
1. **Volatility reduction** — eliminates FX-driven variance, lowering total portfolio vol.
2. **Currency return expected to be zero** over long horizons in developed markets (UIP, PPP).
3. **Benchmark clarity** — compare manager alpha to local-currency indices.
4. **Liability matching** — USD-liability pension fund reduces asset-liability mismatch.

**Arguments against hedging**:
1. **Cost** — hedging costs include forward points (interest rate differential) and transaction costs; rolling 1-month hedges can cost 50–150bps annually.
2. **Currency provides diversification** — USD often acts as a safe haven, so unhedged foreign holdings can outperform in US-risk-off episodes (reverse correlation).
3. **Currency carries risk premium** — carry trades (long high-yield EM currencies) historically positive.
4. **Tax and cash flow issues** — hedges require margin/collateral, create periodic cash settlements, and may trigger taxable events.

**Empirical result**: Over 1990–2024 for US-based investors, hedged EAFE returned ~6.9% annualized with 14.2% vol; unhedged EAFE returned ~7.3% with 17.5% vol. Unhedged had slightly higher return (tailwind from occasional USD weakness) but materially higher vol.

Worked example: Driftwood Endowment has $500M international equity. Unhedged risk = 17.5% × $500M = $87.5M 1σ. Hedged risk = 14.2% × $500M = $71M. Hedging saves $16.5M in 1σ terms. Hedging cost ≈ 60bps = $3M/year. Trade-off clearly favors hedging for this USD-liability endowment.

**Common practice**: Hedge 50% as default (rebalance half risk of being wrong on FX direction), or hedge EM less (higher costs, carry premium) and developed more.

Should international equity returns be currency-hedged?

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