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To hedge or not to hedge? For investors, that is the question

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.

Hedge Fund
Pierre Desrosiers | Getty Images

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.

"A look at recent international equity ETF assets and 12-month net flows shows that a significant number of U.S. investors have put their money in 100 percent hedged currency strategies."

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.

Looking at the relationship of the U.S. dollar to the euro and the yen over a 10-year period ending in 2014, you find that increasing the currency-hedged percentages did steadily reduce the volatility in the developed European and the broader-developed international markets; however, the reverse held true for Japanese markets.

The variation in these results is due to differences in correlation between the currency return and the equity market return in local currency. This correlation has been strongly negative for Japan; therefore, the unhedged currency exposure has provided a natural hedge against fluctuations in the Japanese stock market.

Hedging currency risk effectively reduces this natural hedge, and thus, volatility rises as the currency hedge percentage increases. The correlation has been positive in developed Europe, which means that currency exposure has added to equity risk, and hedging this exposure has reduced volatility.

This further highlights the complex interaction of global markets and the difficulty of trying to manage risk by taking a directional position on currencies.

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The U.S. dollar doesn't always move in the same direction across all currencies. Consider, for example, that during the period 2008 to 2013, a 100 percent hedged approach was never the strongest performer in the same year for both European and Japanese equity markets.

One possible solution is a neutral 50 percent currency hedge. This can help gain international equity exposure and mitigate the effect of exchange-rate fluctuations, without being actively bullish or bearish on the direction of the U.S. dollar or foreign currencies.

A look at recent international equity ETF assets and 12-month net flows shows that a significant number of U.S. investors have put their money in 100-percent-hedged currency strategies. Much of this net flow occurred after the recent large U.S. dollar gains.

As a matter of timing, this means they have not fully benefited from the hedge when it was most needed, and now their portfolios are increasingly vulnerable to any declines in the U.S. dollar.

This once more highlights the difficulty of timing a market — especially internationally, where maximizing returns requires getting both the local market and currency movements correct. With this in mind, strategies that mitigate currency impact, both on the long and the short side, are worth considering.

— By Adam Patti, CEO of IndexIQ