When investing in the U.S. stock market, non-U.S. investors take on both equity risk and currency risk. Adverse moves in exchange rates can dramatically affect investment outcomes. Currency hedging is one technique that is designed to take currency risk out of the equation when investing in the U.S. market from overseas.
This paper examines the mechanics and the potential benefits of currency hedging, using the U.S. equity market as an example, from the perspective of international investors. We explore the impact of currency risk on performance, the methodology of the S&P 500® Currency Hedged Indices, as well as key factors to consider when overlaying a currency hedge on a portfolio.
IMPACT OF CURRENCY RISK ON PERFORMANCE
Currency risk can threaten returns as a result of changes to foreign exchange rates. In Exhibit 1, we compare the historical performance of the S&P 500 calculated in U.S. dollars with its counterpart in Japanese yen. The only difference between these two return series is the reporting currencies, thereby representing the currency risk impact. Please see the appendix for the performance of the S&P 500 denominated in other major Asian currencies.
The impact of currency risk can be substantial depending on the magnitude of dislocation in the currency market. Exhibits 1 and 2 show that returns of the S&P 500 in U.S. dollars versus the S&P 500 in yen differ noticeably between June 2007 and January 2012, and between September 2012 and July 2015.
During the first period, the U.S. dollar depreciated significantly relative to yen, thus a yen-denominated investor would have received negative currency return, decreasing the gains that could have been derived from investing in S&P 500. However, during the second period, the U.S. dollar appreciated against the yen, so a yen-based investor would have benefitted from positive currency returns, magnifying the expected investment outcomes.
A non-U.S. investor who wishes to avert divergence from investment objectives should carefully take currency risk into consideration.