Chapter Sixteen
Trimming the Hedges
Currencies confuse even the experts.
GLOBAL INVESTING PRESENTS another significant variable to investing only in U.S. stocks and that is currency. Foreign stocks are quoted in foreign currencies. While a foreign stock may rise in its quoted currency, if the currency falls in relation to your own base currency, you may lose part or all the benefit of the rising stock price. In the 1980s, until the introduction of the Euro, we had to deal with approximately 20 currencies among the developed countries of the world, and they all fluctuated vis-à-vis each other. Trying to figure what the Italian lira was going to do versus the Spanish paseta versus the U.S. dollar would have been a challenge for Einstein. Sometimes these fluctuations were mild; other times they could be dramatic. In the period from 1979 through 1984, the value of the British, French, German, and Dutch currencies declined between 45 percent and 58 percent against the dollar. Similar declines in the Standard & Poor’s index would have driven investors into cash with lightning speed. Given this complexity and volatility, it makes sense to hedge your investments in foreign stocks to eliminate the effect of currency fluctuations vis-à-vis your base currency. With the introduction of the Euro in 1999, the currency problem has become much less complex. Instead of having investments spread over 20 or so currencies, you will probably have 90 percent of your investments in 4 currencies: the Euro, the British pound, the Swiss franc, and the Japanese yen.
Hedging is fairly simple. If you buy 1,000 pounds of British Tool and Die, you are not only betting on the stock, you are betting on the British pound. If the stock goes up but the pound goes down, you can lose part or all of your gain in the stock if you sell and convert your proceeds back into dollars. Conversely, if the stock goes down but the pound goes up, the rise in the currency may eliminate your loss in the stock. You can create many permutations of this exercise, and it can all get a bit confusing. However, if you hedge your investment in the 1,000 pounds that you now own by virtue of buying the British Tool and Die stock, you will only enjoy or suffer the results depending on whether the stock rises or falls in British pounds.
Here is how it works. Your investment in the stock was worth 1,000 pounds when you bought it. Since the stock is valued in pounds, you own the equivalent of that amount of currency. To eliminate the currency risk, you sell 1,000 pounds using something that is called a currency forward contract. It is like selling a stock short. You don’t own the stock, you just borrow it. With the currency forward contract, you don’t own the currency either, but you do own the equivalent amount in your British Tool and Die stock. You are hedged. You are long and short two instruments that are equal in value. When you sell your stock, you simply close out the contract and get paid back in dollars.
There is another school of thought on foreign currency investing. Most investors who buy foreign stocks do not hedge their currency exposure. They simply accept the added fluctuations that come with foreign stock investing and let the chips fall where they may. Long term, 10 years or more, the investment results for being hedged or not being hedged are pretty similar. Both methods have in common a choice to be currency agnostic. Either you don’t want any currency effect, or you don’t care. A recent study by the Brandes Institute bears this out. Results from year to year can differ significantly, but long term, the currency movements tend to cancel out. The choice is up to the investor.
What does not work is switching from a hedged to an unhedged approach depending on how you think currencies will fluctuate. Again, the Brandes study reaches the same conclusion. Those who attempt to divine currency movements have generally had poorer results than those of us who choose one method and stick with it. I have always taken the position that what I think I know how to do is analyze companies, not countries. I like to stay within my circle of competence.
