Hedging example doesn’t tell the whole story

If you’ve been traveling to Europe lately, or just keep up with these things, you may have noticed that the U.S. Dollar has been getting stronger. A lot stronger. This is fantastic if you are in France buying a baguette or in Germany buying a BMW. Both are cheaper in terms of the number of dollars it takes to obtain them. But if you are a manufacturer trying to sell your goods in Europe, the strong dollar bites the other way. Your products look more expensive to those folk buying them with their Euros. As such you are either not as competitive and thus will not sell as many, or you’ll have to lower your prices. Either way hurts profits.

A stronger dollar is important to investors, too. Companies depending more on imports are helped, those needing to export to make a living are hurt. But there’s another side of this: International investing. If you, or the mutual fund you own, buy stock in an Italian company, it will likely do so in Euro. If that company’s stock goes up 10% you might make 10% return on your investment. “Might” because you don’t spend Euro, you spend Dollars. If in that same year the Italian firm’s stock rose 10% and the Dollar got 10% stronger to the Euro, you would effectively have made nothing. The strengthening dollar will have wiped out your profits.

An easy way to see this is with the PIMCO Global Bond Fund. This fund comes in two versions, one that is hedged and one that is not. Hedging uses financial magic (okay, it’s not magic, but I don’t have the space to explain it now) to make currency fluctuations go away. Hedging is not free, however, and the cost of doing so will have a drag on the portfolio’s return. But with a strengthening dollar, it’s worth it, right? Well, maybe.

If we look at the hedged version of that global bond fund we see that in 2013 and 2014 it returned -0.81 and 9.69% respectively to those owning the fund. The unhedged version during those same years did -5.04 and 2.37%, woefully underperforming the hedged fund. This shows both the effects of the strengthening dollar on foreign investments and how hedging out the currency risk can help with that.

But that’s not the whole story, for while across the last five years (2010-2014) the hedged fund did a lot better, during the five years previous (2005-2009) the opposite was true. In fact the unhedged fund beat the hedged fund in 2011, 2010, 2009, 2007, and 2006—exactly half of the last 10 years.

In other words, hedging only works when it works. And it only works if the U.S. Dollar is getting stronger against the currency of the country in which you have investments. So to use it wisely, all you have to do is know whether the dollar is going to get stronger or weaker. Good luck with that.

Next week we’ll look at whether or not you should hedge out your currency risk or just let it be.

This article was published under the title "Hedging example doesn't tell the whole story" in the Wichita Falls Times Record News on June 14, 2015.