Last week reader Mustachian Post sparked an interesting discussion on exchange rate fluctuations in the comments of an article on the different foreign withholding tax regimes in a number of European and North-American countries. Because exchange rates, together with foreign withholding taxes, form one of the bigger head-scratchers to international investors, I wanted to devote a post to the topic. Do we need to hedge against exchange rate fluctuations or not?
If you’ve ever been abroad, you most likely already had to deal with the annoyance of foreign currencies and cash. Not only is it a hassle to get your hands on foreign banknotes, but everytime you want to buy something you have to whip out an imaginary calculator in the back of your head to determine how much you’re actually paying for something. Now imagine that while you are standing at the counter waiting for the store clerk to finish wrapping your purchase, the value between your home and the foreign currency constantly changes.
You’ll never be able to correctly determine how much you are forking over for the product you’re buying!
Exchange rate fluctuations
That’s exactly what exchange rate fluctuations are all about. Because most developed currencies are free-floating, it’s impossible to predict the value of an asset in a foreign currency at any given point in the future. For example, since I put my Euros to work in late August by purchasing McDonald’s (NYSE:MCD), which is denominated in United States Dollars on the NYSE, the Euro has lost about 10% of its value compared to the Dollar.
That means my shares of McDonald’s are now worth 10% more in my home currency than when I bought them just four months ago without the underlying value of McDonald’s changing one bit. In this example that’s a good thing, but imagine if the reverse had happened? I would have lost 10% of equity value.
It’s obvious that exchange rates influence the return of investments. Indeed, international investments carry the risk that any return on those investments changes unfavourably or favourably because of a different exchange rate at the time of purchase, and the moment a dividend is received or the investment is sold.
The solution to the problem described above is to hedge or eliminate the foreign exchange risk. Many businesses that conduct operations across borders do so by buying a hedge from a financial institution. Currency hedges are a type of derivative aimed at either locking in an exchange rate today for a transaction that will occur in the future, or at exercising a previously agreed upon exchange rate at a future point in time.
Without going into the nitty gritty of hedging methods and best practices, it’s clear that buying into a hedge is an elegant solution to the problem of changing exchange rates. A business won’t have to worry about the value of its products abroad as it agreed upon a pre-determined exchange rate between its home and the foreign currency with a bank.
An investor can furthermore rest assured that the return on his investments is simply the return of his foreign portfolio minus the cost of the hedge, instead of the return of his foreign portfolio plus the foreign currency return.
Do you need to hedge?
Sounds like a no-brainer to hedge against currency fluctuations then, doesn’t it? That would seem to be the logical conclusion, but the answer probably isn’t as clear-cut as some of you would have liked. Let’s consider the following three scenario’s:
|No action taken
|Hedged your position
|Lost cost of hedge
|Gained currency return
|Lost cost of hedge
|Lost currency return
|Didn't lose currency return
As it turns out, an investor not using a hedge only has a one in three chance of a negative outcome due to currency fluctuations, whereas a cautious investor who hedges his positions loses two out of three times. There is a big but, however! When the first investor loses money, he potentially loses a lot of it. The second investor can only lose the cost of the hedge, but saves himself the trouble of potentially massive currency return loss.
You can see that hedging carries with it a certain level of opportunity costs. Not only will you lose the cost of the derivative when you hedge, but you also potentially lose out on the added returns of foreign currency appreciation. That’s why hedging or not becomes a question of predicting currency movements, especially over longer periods of time. Everyone saw the pullback of the Euro coming in August following the lower ECB rate announcement, but nobody can predict the Euro’s movement three years from now with certainty.
As an invidual investor you should therefor ask yourself the following question:
Is the risk and consequent cost of making a loss on an investment due to fluctuating exchange rates in the long-run bigger than the cost of hedging against that possible fluctuation.
The answer to that question isn’t immediately obvious because we can’t know what the future holds.
What about other dividend growth investors?
Because I’m mostly interested in dividend growth investing, I’ve chosen to take a quick peek at some other bloggers following the same strategy to see if any of them hedge their foreign positions. Of course, I might as well have looked at people trying their hand at passive index funds because the same principles apply to any type of investment where multiple currencies are concerned.
You’ll be surprised to find that I’ve found nobody, both in Europe as well as overseas, who hedges against currency fluctuations or openly states doing so. Dutch investors Pollie and Dutch Dividend buy their foreign shares outright with their monthly net worth updates showing that changing exchange rates do indeed influence the value of their portfolio. Finnish Dividend Hawk also doesn’t seem to be using a hedge.
Dividend investors based in the US often don’t buy stocks on foreign exchanges, but make use of ADRs listed on the NYSE. These certificates are denominated in Dollars, but represent an underlying foreign security. When Dividend Mantra, for example, buys another batch of Unilever shares in New York (NYSE:UL), he’s also exposing himself to currency exchange risks because Unilever’s actual stock is listed in London in GBP and Amsterdam in Euros. To my knowledge he doesn’t hedge against this risk.
Keith from DivHut, someone who I believe to be very conservative and careful in his investments, also doesn’t mention hedging his foreign positions. He too is exposed to the risk of exchange rate fluctuations through his positions in, again, Unilever and Diageo (NYSE:DEO). Both companies originate from the London Stock Exchange where they are denominated in British Pounds.
The only blogger that I’ve found who discussed the effect of strengthening and weakening currencies is Stef from Grow Independent. Coincidentally, he did so only last week in one of his portfolio updates because he found that the strengthening Dollar and dropping British Pound had a significant effect on his stock purchasing power and dividend income. His conclusion was to not take currency volatility into consideration, but to focus on individual company quality instead.
Yours truly also doesn’t try to offset the effects of currencies appreciating or depreciating over time. At the time of writing most of my Dollar denominated holdings are up, simply because of the Euro depreciating, for example. There are two main reasons for not hedging my portfolio. First, the total value of my portfolio doesn’t matter all too much as long as its dividend income remains stable. Second, as long as I’m not living off my passive investment income, a short-to-medium-term dip in dividends won’t derail my progress.
As you can see, there’s no single argument in favour or against hedging your foreign positions or not. Rather, it’s a question of personal preference. I believe putting a hedge in place has its uses, but only for shorter periods of time or in times of exceptionally great currency volatility.
However, because it’s not possible to assess currency movements in the long-run, I believe it foolish to expect improved returns from currency hedging if you’re investing for the long-haul. By introducing a hedge into your portfolio you are actually making a bet against a particular undesirable outcome in the future, which has the exact same merit as not hedging international stocks.
In my opinion, it’s far more important to build a stable and well-diversified portfolio. When the US Dollar depreciates, for example, a British investor owning a piece of a US company like Procter and Gamble (NYSE:PG) might worry about his return. However, if he had taken a closer look at his investment, he might have noticed that 61% of PG’s revenue comes from outside of North-America.
As a result, the depressed Dollar would lead to a potentially higher operating profit for Procter and Gamble’s foreign operations, which in turn results in increased future dividend payouts. Futhermore, you can rest assured that all multinationals have a certain degree of currency hedging in place to protect their own assets and products abroad. Nothing is more worrisome to an internationally active corporation than declining profits because of external factors.
To top things off, if the British investor also diversified his own portfolio by adding PG’s biggest UK-based competitor Unilever, he would probably sleep even better at night. When Procter and Gamble finds itself in a weakened position, it’s highly likely that Unilever will step in to pick up its slack.
What do you think about currency hedging? Do you think it is necessary to protect the return of your foreign investments or not?