In Thinking About Your Investments we discussed framing your financial view in a way independent of a currency anchor. A currency is a security like any other, except we use it as our default unit of value. But as we discussed, this introduces distortion into our thinking because a currency is not inherently any more superior than other assets as a standard of value. Our choice may be one of habit, or even government fiat, but it’s not one forced by the laws of economics.
We also cited some ways in which our investment decisions might be improved as a result of removing these distortions. Let’s take a look at another one.
Investors are sometimes urged to hedge investments for currency risk. There are a number of investment funds on the market with such hedging built in. For example there are a number of exchange traded funds (ETFs) marketed in the US for investing in other national stock markets on a currency hedged basis. This basically means that the investor receives, after expenses, the return of that foreign market in the foreign currency, but translated into US dollars. A European stock fund might return, say, 15% in euros, and the hedging operation then translates that into a gain of 15% in dollars.
But looked at in our clearer frame of reference, we can see flaws in the line of thinking the strategy is based on. It assumes that the local currency performance of that market is the “real” performance, and that if we invest on an unhedged basis we incur an additional risk of loss due to currency translation. But this isn’t true … if we own those stocks the only investment performance we will experience is that of the stocks. If we hedge for “currency risk”, in fact we’re layering on an additional speculation on the relative performance of the currencies involved.
Why? No currency is absolute. The performance of European stocks as measured in euros is no more real than the performance of those stocks as measured in yen. In the first case, the return being measured is the ratio of return of the European stocks to that of the euro. It’s a relative return, not an absolute one. In the second case, we’re looking at the return of European stocks relative to the Japanese yen. While it may seem natural enough to use European currency to measure the return of European stocks, there’s nothing inherently different in using another choice of units … no matter what unit we select, we cannot eliminate the variation in the unit itself from the return calculation. All prices are ratios … ratios of the value of the thing being priced to the value of the currency used to price it.
The return of those European stocks is the same no matter unit what you use to measure it. If the numbers come out different measured in different currencies, it’s solely due to changes in the value of the currencies.
This doesn’t mean of course that there’s never a valid reason for currency hedging. But it does mean that it’s adding, not subtracting, a currency risk.