Time for the “Hedge of Least Regret”?

A 50% currency exposure; something we have long called the “hedge of least regret,” and never has that seemed more true than this year. The U.S. dollar has been on an epic tear, up about 19% year-to-date (YTD) against key trading partners as measured by the ICE U.S. Dollar Index, the best year since 1985 (CNBC, September 26). An aggressive Federal Reserve has pushed up interest rates further and faster than many of its central bank peers and that, in turn, has altered capital flows in favor of the higher yielding U.S. currency.

The impact of a higher dollar falls most heavily on exporters and those companies that do business outside the U.S. and report earnings back to the corporate parent here. Simply put, it takes more Euros and Yen to buy the same dollar than it did last year. There is a similar negative impact on investment returns generated internationally for US investors.

It’s always hard to anticipate shifts of this magnitude. Who knew, for example, that the United Kingdom would cut tax rates, leading to a massive selloff in the British pound? Or that the Bank of Japan would intervene in the currency market for the first time since 1998 as the yen plummeted to its lowest level in two and half decades? Or that the Euro would drop below dollar parity? Those are the kinds of exogenous events that keep investors awake at night.

Even in the best of times there will be differences in regional economic performance. Central banks will sometimes move in contrary directions on interest rate policies. These times, of course, have been more challenging, as war in the Ukraine and energy and food shortages have contributed to persistently high levels of inflation and the rapid rise in interest rates around the world.

While the dollar appears poised for further gains, history has shown that the kind of price movements experienced earlier this year can quickly unwind, too. And that’s where the hedge comes in. Currency hedging allows an investor to maintain or gain exposure to international assets without making a directional bet on the dollar. It has the potential to lower volatility as well by dampening currency swings. It is, in short, a hedge against the unexpected.

One way to gain neutral currency exposure to the international markets is the IQ FTSE International Equity Currency Neutral ETF (HFXI). HFXI utilizes a 50% hedge to provide ballast against currency fluctuations, while maintaining exposure to international equities.  This simple concept of a ‘best of both worlds’ exposure, both participating in a portion of foreign currency strength, and dampening the negative impacts of US dollar strength, provides an investor with a neutral choice to investing internationally. Considering the sharp, and in some cases historic, movements in the foreign exchange market this year, a neutral currency approach can provide just the kind of portfolio protection that international investors are seeking.

And that brings us to one final point worth noting… While international markets have generally underperformed the U.S. of late – especially in dollar terms – that, too, is subject to change without notice. It’s not impossible to imagine a scenario where non-U.S. markets outperform and the dollar gives back some of its gains. In that instance, it would be helpful to have exposure outside the U.S. consistent with overall portfolio diversification. HFXI provides a way to do that without courting the potential “regret” of going all in on a currency. Completely hedged? Completely unhedged? Perhaps somewhere in between is best, which is why we’ve long been advocates of the “hedge of least regret.”

Related: A “Charlie Brown” Kind of Month