Executive Summary: Currency risk hasn’t rewarded investors in foreign stock funds—but most funds, including Vanguard’s, still don’t hedge it. I examine the case for and against hedging, the data behind the debate and why it may be time for Vanguard to offer a currency-hedged option.
In part one of this two-part series on currencies in your foreign stock and bond funds, I made a clear-cut case that currency risk has no place in a bond fund. Hedge it and move on—just as Vanguard does.
But foreign stock funds? That’s where things get more complicated.
Though you wouldn’t know it from looking at Vanguard’s fund lineup. While the firm hedges currency exposure in its bond funds, it leaves stock investors fully exposed to the whims of global currencies—with one exception: Global Minimum Volatility (VMVFX). (And the name offers a pretty strong clue as to why that fund hedges currency risk.)
You might assume Vanguard’s approach reflects the data—that currency-hedged stock funds simply don’t hold up under scrutiny. But that’s not quite the case.
So, let’s turn the page and dive into the tougher questions: Should foreign stock funds hedge currency exposure back to the dollar? And if so, what’s a Vanguard investor to do?
As always, I’m looking at this through the lens of a long-term investor—not a trader. If you need a refresher on how currency hedging works, I’ve got you covered here.
Key Points
- Over the past 35 years, hedging currency risk out of foreign stocks would have added 2% per year to returns and lowered your risk.
- One reason why you might not want to hedge all of your foreign currency exposure away is diversification.
- I expect Vanguard to launch a currency-hedged foreign stock fund (probably an ETF) sooner rather than later.
Summary Arguments
Before I walk you through the charts and data, let’s set the stage with the core argument on both sides of the hedging debate.
The Case for Hedging:
Put simply, investors haven’t been rewarded for bearing currency risk over the past 35 years. And as a rule, we shouldn’t take risks that don’t pay.
The Case Against Hedging:
One word: Diversification.
Hedging everything back to the dollar ties your entire portfolio to the U.S. dollar. By owning unhedged foreign stocks, you’re effectively insured against a dramatic drop in the value of the dollar.
Hopefully, that policy never needs to pay out. But if the dollar tumbles, that unhedged exposure can help preserve your purchasing power.
Hedging Helped. No Question.
Let’s turn to the data and start by comparing the performance of foreign stocks with currency hedging (index data and Xtrackers MSCI EAFE Hedged Equity ETF (DBEF)) against foreign stocks without currency hedging (index data and Developed Markets Index (VTMGX)) over the past 35 years.