In Thinking About Your Portfolio 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. But in most cases it amounts to adding a currency risk, not cancelling out one, as might be implied by the term “hedge”. 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 due to currency translation. But this isn’t true … if we own those stocks or bonds the only investment performance we will experience is that of the stocks or bonds. 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 foreign securities as measured in their local currency is no more real than the performance of those as measured in yours. In the first case, the return being measured is the ratio of return of the foreign securities to that of the foreign currency. It’s a relative return, not an absolute one. In the second case, we’re looking at the return of the foreign securities relative your domestic currency.
The return of those foreign securities 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. Changing from one currency to another is a simple change of units, but the underlying quantity remains the same. Like the temperature outside being 10°C or 50°F … you have a different reading but the actual temperature is the same.
As an example let’s assume, say, a US investor buying Japanese stocks. You buy the Nikkei index. You find that the return you get is different than what’s reported for the Nikkei. But that’s because of the convention of reporting the Nikkei itself in Japanese yen. If you were to calculate the Nikkei in dollars, the Nikkei would be reported differently. You may be told you must “hedge” the currency to “protect” your returns. That’s a fallacy.
The “hedging” argument is based on the assumption that the yen-based calculation is the “real” performance of the Japanese stock market. And that your performance in another currency is somehow deficient. It’s not … it’s just measured using a different unit. The real performance of your collection of Japanese stocks is the same either way.
So suppose you “hedge” by an offsetting position in the dollar/yen. You can now match the yen-based performance of Japanese stocks in dollars. But this is not the same actual, real, return … what you’ve actually done is changed the return on your “Japanese stocks” investment by adding a currency trade.
In reality, you haven’t “hedged” anything … you’ve added a currency position to your stock position in order to make your dollar-based return look the same as the one reported in yen!
It’s as if you heated the temperature up to 50°C to make it look like the same as 50°F.
Now the result may (or may not) be better than if you hadn’t “hedged”. But if so, it’s because you added a profitable currency trade, not because your hedge has protected you against currency losses and allowed you to capture the “real” performance of Japanese stocks.
Although we’ve used stocks in this example, none of this is unique to stocks. Or to US investors buying overseas. The same logic would apply for example to a non-US investor buying US bonds.