Don't add currency risk on top of equity risk

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CULater
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Don't add currency risk on top of equity risk

Post by CULater » Tue May 21, 2019 5:29 pm

Here's my position:

When investors purchase foreign equities they are assuming both equity risk and currency risk. It is assumed that the currency risk is embedded in the equity risk, but it isn't. The currency risk exists on top of the equity risk when owning foreign equities.

Why should you assume that additional currency risk? The answer is usually that currency exposure enhances portfolio diversification. Well, no. If that were true, then the added currency exposure should decrease overall portfolio volatility or enhance risk-adjusted returns. But it doesn't. In fact, exposure to unhedged foreign equities has generally increased portfolio volatility. That's the reason that Vanguard's global low volatility fund gives for hedging foreign currency exposure. This is also the reason that it is recommended to currency hedge foreign bond exposure - the volatility of currency exposure is greater than the volatility of the underlying bond assets.

Well, maybe then assuming currency risk is sort of like insurance against a fall in the USD. Actually, if that's the way you look at it, you should invest directly in foreign currencies. it's more like a bet against the USD. You might win -- or you might lose. Betting (speculating) is not investing. Buying equities is investing -- adding currency risk adds speculative risk on top of the equity risk.

Another way to look at it - would you want to own both Japanese equities and the Yen as a diversifier? Well, no. In fact, owning either the Yen or Japanese stocks (hedged) as standalone investments would be a more effective diversifier for a bearish scenario in U.S. stocks than owning both. Historically, there has been a large negative correlation between Japanese stocks and the Yen. Holding an exposure to both foreign equity risk and foreign currency risk often cancels some of the diversification benefit of each.

One might actually view owning both foreign equity risk and foreign currency risk is actually more exotic than simply owning foreign equity risk alone, which should be the default option. And owning currency hedged foreign equity investments is pretty inexpensive these days and much more commonly available. Why not do it?
Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith

columbia
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Re: Don't add currency risk on top of equity risk

Post by columbia » Tue May 21, 2019 5:33 pm

iShares had an easy way around this - HACW: a currency hedged global cap fund.

It folded a few years ago. :x

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Re: Don't add currency risk on top of equity risk

Post by JBTX » Tue May 21, 2019 6:57 pm

CULater wrote:
Tue May 21, 2019 5:29 pm
Here's my position:

When investors purchase foreign equities they are assuming both equity risk and currency risk. It is assumed that the currency risk is embedded in the equity risk, but it isn't. The currency risk exists on top of the equity risk when owning foreign equities.

Why should you assume that additional currency risk? The answer is usually that currency exposure enhances portfolio diversification. Well, no. If that were true, then the added currency exposure should decrease overall portfolio volatility or enhance risk-adjusted returns. But it doesn't. In fact, exposure to unhedged foreign equities has generally increased portfolio volatility. That's the reason that Vanguard's global low volatility fund gives for hedging foreign currency exposure. This is also the reason that it is recommended to currency hedge foreign bond exposure - the volatility of currency exposure is greater than the volatility of the underlying bond assets.

Well, maybe then assuming currency risk is sort of like insurance against a fall in the USD. Actually, if that's the way you look at it, you should invest directly in foreign currencies. it's more like a bet against the USD. You might win -- or you might lose. Betting (speculating) is not investing. Buying equities is investing -- adding currency risk adds speculative risk on top of the equity risk.

Another way to look at it - would you want to own both Japanese equities and the Yen as a diversifier? Well, no. In fact, owning either the Yen or Japanese stocks (hedged) as standalone investments would be a more effective diversifier for a bearish scenario in U.S. stocks than owning both. Historically, there has been a large negative correlation between Japanese stocks and the Yen. Holding an exposure to both foreign equity risk and foreign currency risk often cancels some of the diversification benefit of each.

One might actually view owning both foreign equity risk and foreign currency risk is actually more exotic than simply owning foreign equity risk alone, which should be the default option. And owning currency hedged foreign equity investments is pretty inexpensive these days and much more commonly available. Why not do it?
I think you hit it with the Japan example. You are hedging against potentially catastrophic scenario where the markets and currency both go down. There may be other ways to hedge home currency risk, but if you aren't an investment bank or fortune 500 treasury department your options are limited.

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Re: Don't add currency risk on top of equity risk

Post by Thesaints » Tue May 21, 2019 7:33 pm

Over the long term, volatility introduced by currency exchange fluctuations is small compared to the natural volatility of stocks.
The story is different for bonds.

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Re: Don't add currency risk on top of equity risk

Post by Jayhawker » Tue May 21, 2019 7:50 pm

I'm definitely intrigued by the idea of hedging currency. In the past the USD has strengthened in times of global crisis, leaving Americans investing in international stocks with a double-whammy of both the stocks and the foreign currency going down at the worst time.

What's the best vehicle you have found for investing in a hedged manner?

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Re: Don't add currency risk on top of equity risk

Post by Northern Flicker » Tue May 21, 2019 7:53 pm

Currency diversification and int'l equity exposure help protect against the risk of robust inflation in one's home country. Hedging the currency defeats much of that benefit.

Int'l equities in their home currency denomination and the currency of that country valued against a basket of reserve currencies tend to have mild negative correlation. This means that variance, aka shorter-term risk of hedged int'l equities may be higher than unhedged int'l equities.

I believe that for most US investors, unhedged int'l equity diversification offers more benefits than diversification with hedged int'l equities.
Last edited by Northern Flicker on Tue May 21, 2019 10:25 pm, edited 1 time in total.

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Re: Don't add currency risk on top of equity risk

Post by Thesaints » Tue May 21, 2019 7:56 pm

There is a study published by Vanguard just a few years ago showing how currency hedging is inessential for stocks and instead is necessary for bonds. However, their minimum volatility fund is currency-hedged.

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Re: Don't add currency risk on top of equity risk

Post by Slick8503 » Tue May 21, 2019 8:26 pm

Volatility is obviously not the only form of risk.

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Re: Don't add currency risk on top of equity risk

Post by Sandtrap » Tue May 21, 2019 8:37 pm

Fascinating points.
Thanks for posting it.

j :happy
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Re: Don't add currency risk on top of equity risk

Post by nedsaid » Tue May 21, 2019 9:59 pm

Northern Flicker wrote:
Tue May 21, 2019 7:53 pm
Currency diversification and int'l equity exposure help protect against the risk of robust inflation in one's home country. Hedging the currency defeats much of that benefit.

Int'l equities in their home currency denomination and the currency of that country valued against a basketof reserve currencies tend to have mild negative correlation. This means that variance, aka shorter-term risk of hedged int'l equities may be higher than unhedged int'l equities.

I believe that for most US investors, unhedged int'l equity diversification offers more benefits than diversification with hedged int'l equities.
That is my take too. I want some currency diversification in my portfolio.
A fool and his money are good for business.

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Re: Don't add currency risk on top of equity risk

Post by MotoTrojan » Tue May 21, 2019 10:19 pm

Volatility isn’t so bad if it’s not correlated with your equity volatility.

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Re: Don't add currency risk on top of equity risk

Post by pdavi21 » Wed May 22, 2019 2:25 am

Many use currency risk as a reason to tilt away from INTL.

There are other reasons to and also reasons to tilt away from US.

I don't think uncompensated currency risk is a big deal because global diversification benefits are free(ish).
Uncompensated risk increase minus free risk reduction.
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Re: Don't add currency risk on top of equity risk

Post by minimalistmarc » Wed May 22, 2019 3:06 am

currency markets are extremely efficient.

My choice as a U.K. investor is to invest in unhedged all world ETF. Hedging adds costs usually.

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Re: Don't add currency risk on top of equity risk

Post by jose » Wed May 22, 2019 4:01 am

I think there is an illusion of currency denomination of assets that confuses many people between holding assets and holding currencies. The currency in which an asset is denominated does not really matter. Any fluctuations in the currency will be compensated by the value of the asset in those currencies.

Example 1. Gold. It does not matter if you buy it in dollars or Turkish liras. It is gold.

Example 2. The same fund denominated in Euros or in Dollars. It does not matter, you are buying the asset, not the currency.

Example 3. Stock of a global (multinational) corporation. It holds assets all over the world, and has revenues and expenses globally. You can denominate it in any currency, it does not matter. You can also move the HQ and "home country" to whatever country. It is still the same thing. Example: BMW vs. General Motors or Toyota. How are they linked to currencies? They are fully diversified, by their nature.

So, to put currency risk "on top" of equity risk you would have to compare home 100% domestic vs. foreign 100% domestic firms. This means firms that hold all their assets, operate and sell 100% in the same currency. That does not happen even in small firms.

Most people here hold equities in index funds of multinational corporations. Currency fluctuations are very dampened by internal translation, economic performance, international trade, and so on. Especially in the medium or long term where purchasing power parity, international Fisher effect, and other parity conditions go into equilibrium.

SO, if one invests in large multinational firms, one is exposed to a similar basket of currencies, regardless if it is a domestic of international fund.

Please correct me if I am wrong. Has anyone reviewed empirical literature on currency fluctuation and value of foreign equities?

Jose

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Re: Don't add currency risk on top of equity risk

Post by xavierr » Wed May 22, 2019 4:41 am

I tend to agree that foreign currency risk generally adds risk to a US investor’s portfolio (it’s different for non-US investors). In a bear market, there is a flight to quality: investors sell risky assets to buy non-risky assets. US treasuries rally and so does the US dollar. If you’re holding foreign stocks unhedged, you will lose on the stock market decline, and you will also generally lose on the currency conversion (because the US$ has appreciated and the foreign currency you are holding has depreciated). This phenomenon is well documented.

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Re: Don't add currency risk on top of equity risk

Post by gjlynch17 » Wed May 22, 2019 5:44 am

I have read and thought a lot about international investing and currency risk in the last year. As this discussion shows, there are a lot of factors involved and the ultimate decision on whether to hedge currencies in international equities is a personal decision based on one's overall portfolio, diversification strategy and risk tolerance. I have gotten comfortable with unhedged equities for the following reasons:

1. During the investment accumulation phase, the additional volatility of currencies of helps a dollar cost averaging investment strategy.

2. During the retirement/withdrawal phase, currency exposure provides an additional hedge against inflation risk in the U.S.

3. I am not aware of any great investment vehicles to cost-effectively hedge currency risk. iShares has some interesting currency hedged funds but the expense ratios are 30-50bp higher than comparable unhedged funds. And this does not include costs of hedging (which I understand are only a few bp annually). https://www.ishares.com/us/literature/p ... brief.pdf

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Re: Don't add currency risk on top of equity risk

Post by nisiprius » Wed May 22, 2019 6:24 am

I've yet to see a thoughtful or quantitative analysis of just what currency risk does. One that puts numbers on "how big it is" or "how much it matters."

It definitely invalidates the assumptions that are behind the theorem by which the market portfolio is the optimum, because it invalidates the assumption of a frictionless market--cross-border (or at least cross-currency) trades incur "friction" in the form of currency fluctuation.

My personal view is that currency risk is big enough to matter--it's not totally invisible compared to intrinsic stock risk--but it's not gigantic. When you are buying unhedged international bonds, currency risk dominates--you don't really have a bond investment, you really have mostly a currency investment with a little bit of "bond" characteristics added. When you are buying unhedged international stocks, stock risk dominates--you have mostly a stock investment with a little bit of bond characteristics added.

You can't discuss it in qualitative absolutes. You have to have some measure of how much the risk is, and to what extent it is or is not compensated by additional return, or by allegedly adding diversification benefits.

The practical facts are that actual statistics of past performance just don't show any dramatic effect one way or another. It's not insanely stupid to be 100% US, it's not insanely stupid to be 100% Vanguard Total World. I believe that as a theoretical matter, just playing argument games, currency risk is not valuable--it's just extra risk, and no reason for it to be fully compensated since not all investors need to take it. Therefore, I think it probably shifts the theoretical ultimate highest possible risk-adjusted return to a foreign allocation that is somewhere below global cap-weight. But probably not to zero.
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Re: Don't add currency risk on top of equity risk

Post by columbia » Wed May 22, 2019 6:41 am

nisiprius wrote:
Wed May 22, 2019 6:24 am
I've yet to see a thoughtful or quantitative analysis of just what currency risk does. One that puts numbers on "how big it is" or "how much it matters."

It definitely invalidates the assumptions that are behind the theorem by which the market portfolio is the optimum, because it invalidates the assumption of a frictionless market--cross-border (or at least cross-currency) trades incur "friction" in the form of currency fluctuation.

My personal view is that currency risk is big enough to matter--it's not totally invisible compared to intrinsic stock risk--but it's not gigantic. When you are buying unhedged international bonds, currency risk dominates--you don't really have a bond investment, you really have mostly a currency investment with a little bit of "bond" characteristics added. When you are buying unhedged international stocks, stock risk dominates--you have mostly a stock investment with a little bit of bond characteristics added.

You can't discuss it in qualitative absolutes. You have to have some measure of how much the risk is, and to what extent it is or is not compensated by additional return, or by allegedly adding diversification benefits.

The practical facts are that actual statistics of past performance just don't show any dramatic effect one way or another. It's not insanely stupid to be 100% US, it's not insanely stupid to be 100% Vanguard Total World. I believe that as a theoretical matter, just playing argument games, currency risk is not valuable--it's just extra risk, and no reason for it to be fully compensated since not all investors need to take it. Therefore, I think it probably shifts the theoretical ultimate highest possible risk-adjusted return to a foreign allocation that is somewhere below global cap-weight. But probably not to zero.
It would interesting to see one of those historical efficient frontier graphs, which managed to factor in a hypothetical currency hedge.

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Re: Don't add currency risk on top of equity risk

Post by CULater » Wed May 22, 2019 7:05 am

Since 1/16 (longest period available), the MSCI ex-U.S. ETF (ACWX) compared to the MSCI ex-U.S. currency hedged ETF (HAWX) (from Portfolio Visualizer):

CAGR 8.13 vs. 8.89
SD 11.42 vs. 10.14
Max DD -18.40 vs. -11.75
Sharpe .65 vs. .79

Clearly, currency risk has been notably negative for U.S. foreign stock investors more recently. CAGR for unhedged MSCI ex-U.S. has been 9% lower, while volatility has been 12% higher and the worst drawdown has been 57% larger. The USD has moved in waves vs. foreign developed market currencies. Given the greater volatility of foreign currencies, one should have some conviction that foreign currencies will move higher relative to the USD in order to compensate for this additional risk -- do you? Once again, this is a speculative bet and not an investment per se.
Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith

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Re: Don't add currency risk on top of equity risk

Post by SovereignInvestor » Wed May 22, 2019 7:10 am

US Large caps like S&P are a good hedge agains the dollar with near 50% of sales coming from overseas.

I'm the 2002-2007 period when the dollar tanked S&P earnings.

Alternatively from 2014-2016 as dollar surged S&P earnings stagnated.

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Re: Don't add currency risk on top of equity risk

Post by jose » Wed May 22, 2019 7:29 am

A stream of research called "the exchange rate exposure puzzle" analyzes the lack of impact of FX exposure on firm valuation.

Firms tend to hedge their transactions to show consistent earnings in their home currencies. This happens in the short therm (within the year) and for transaction exposure and only affects income statement.

Translation exposure affects balance sheet and book value, but not necessarily valuation.

As I said before, US domestic multinational are global firms exposed to multiple currencies, and not "domestic" firms. This is the case of most of the S&P500. I am not sure BMW gives you much higher FX exposure than say Apple.

An international fund holds many firms, so the residual exposure is to the basket of currencies of those firms.

Then, there is domestic inflation (intl. purchasing power parity) which again dampens any residual FX effects either way. For example, if the dollar depreciates in the future, domestic inflation will occur and hedge the gains from foreign equities, and the other way around. I am really skeptical that it has much impact and definitely you don't put FX risk on top on equity risk. Not for a portfolio of multinational firms, and much less in the long term.

It's a complex analysis. Defies market efficiency and international parity conditions.There are arbitrage opportunities. I suspect there is not much research because it is too obvious. I think diversification is the way to go.

jose

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Re: Don't add currency risk on top of equity risk

Post by gjlynch17 » Wed May 22, 2019 7:59 am

nisiprius wrote:
Wed May 22, 2019 6:24 am
I've yet to see a thoughtful or quantitative analysis of just what currency risk does. One that puts numbers on "how big it is" or "how much it matters."
Vanguard has a good discussion in their recent white paper. Their conclusion on currency hedging is that it is appropriate for international bonds but highly specific to the investor for international equities.

https://personal.vanguard.com/pdf/ISGPCH.pdf

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Re: Don't add currency risk on top of equity risk

Post by JackoC » Wed May 22, 2019 8:22 am

jose wrote:
Wed May 22, 2019 4:01 am
I think there is an illusion of currency denomination of assets that confuses many people between holding assets and holding currencies. The currency in which an asset is denominated does not really matter. Any fluctuations in the currency will be compensated by the value of the asset in those currencies.

Example 1. Gold. It does not matter if you buy it in dollars or Turkish liras. It is gold.

Example 2. The same fund denominated in Euros or in Dollars. It does not matter, you are buying the asset, not the currency.

Example 3. Stock of a global (multinational) corporation. It holds assets all over the world, and has revenues and expenses globally. You can denominate it in any currency, it does not matter. You can also move the HQ and "home country" to whatever country. It is still the same thing. Example: BMW vs. General Motors or Toyota. How are they linked to currencies? They are fully diversified, by their nature.
This is a good explanation of the basic misunderstanding of the OP and lots of posts on this forum about foreign stocks. They confuse an asset's unit of account being a particular currency with the asset being a claim on a certain number of units of that currency.

A foreign denominated bond is a claim on a given number of units of foreign currency. US stocks and foreign stocks are not claims on a fixed number of currency units. The sensitivity of their USD value to currency exchange rates is seriously different than assuming they are. And USD values of US stocks also have sensitivity to currency exchange rates, for some big companies it's significant: translation of earnings on foreign operations which don't involve a lot of import/export from the US. The sensitivity of foreign domiciled companies' USD value to the value of the USD tends to be higher than that of US companies, but portfolio effects mean that even adding 'currency risk' to the extent it exists doesn't necessarily raise portfolio risk. That depends on the degree of exposure and the correlations.

The white paper by Vanguard about why they have a given % of unhedged foreign stock in their 'all in one' portfolio but hedged foreign bonds I think has been chewed over here innumerable times. The impact on *portfolio* volatility of adding non-USD unit of account stocks has been positive or negative depending the % of foreign stocks, figure 3, up to ~40%-ish foreign among stocks the effect was a reduction not increase in portfolio vol in the historical data set they used.
https://personal.vanguard.com/pdf/icriecr.pdf

Currency hedged foreign stock funds only make sense for particular currency/domicile pairs and generally assuming a large speculative position in that pair. In a cap weighted approach among foreign currency/domiciles for moderate overall foreign stock exposure it tends not to. And for particular large domicile/currency pairs (for example large cap Eurozone stocks and the Euro) it's pretty apparent that movements in the currency have typically explained relatively little of the movement of the USD value of those stocks.

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Re: Don't add currency risk on top of equity risk

Post by CULater » Wed May 22, 2019 8:42 am

From the Vanguard paper:
Currency has no intrinsic return, but it can add material short-term volatility, thereby introducing performance differences.
Therefore, over the long term, currency exposure adds only return volatility to an investment. Keeping that exposure means added volatility in the short term in the international asset returns, but long-term, minor and fluctuating changes in total return can be expected (Greiner, 2013).
The gist of their conclusion is that currency volatility increases portfolio volatility without adding any intrinsic return, but that over time periods of 20 years or so, this added volatility has had no predictable effect on long term returns for U.S. investors. Couple things: (1) adding currency volatility by means of unhedged foreign investments adds uncompensated return risk, especially for investment horizons that are not long, and (2) there is no evidence that adding currency exposure has actually improved portfolio returns or risk-adjusted returns even over the long run. One might conclude that currency exposure has been at best useless for U.S. investors. This is worth noting, since there is an often-made argument that currency exposure is a beneficial aspect of foreign investment for U.S. investors. The facts argue otherwise. But of course this could change in the future -- but that would be speculation and not investing.
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Re: Don't add currency risk on top of equity risk

Post by acegolfer » Wed May 22, 2019 10:19 am

We have BHers who will argue that there's a diversification effect because currency risk is not perfectly correlated with the equity risk. /s

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Re: Don't add currency risk on top of equity risk

Post by azanon » Wed May 22, 2019 10:46 am

If currencies are ultimately zero-sum over a long period of time, and local currency bonds have lower correlation to other major asset classes than currency hedged one (they do- feel free to confirm at portfoliovisualizer), then I don't need to run any screens to realize that, all things being equal, going with local currency bonds will raise my portfolio's Sharpe ratio.

I actually find "risks" such as currency and duration, to be a least a little odd, since I know that both of those are zero-sum over the long term. In practice, they only end up being "risks" worth worrying about if your time horizon is short. And since the direction of both of those are unknown, that "risk" is just as likely to be a benefit, as it is a detriment. And when you add in rebalancing volatile assets, you don't need to be a math wiz to realize that the higher the volatility, the greater the rebalancing bonus.

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Re: Don't add currency risk on top of equity risk

Post by Pomegranate » Wed May 22, 2019 10:49 am

Well, you can think about it from the opposite perspective - you do introduce currency risk (you bet that USD will be doing better than other currencies) if you avoid international :sharebeer

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Re: Don't add currency risk on top of equity risk

Post by staythecourse » Wed May 22, 2019 11:04 am

Pomegranate wrote:
Wed May 22, 2019 10:49 am
Well, you can think about it from the opposite perspective - you do introduce currency risk (you bet that USD will be doing better than other currencies) if you avoid international :sharebeer
This is how I view it as well. The WHOLE idea of diversification is the "don't hold all your eggs in one basket" in case the basket breaks and all the eggs fall to the ground. If you whole all your assets in dollars vs. a basket of different currency which one sounds riskier? Why would diversification be great for EVERYTHING except for currency diversification? Not sure why others don't see it the same way... actually I do and it is because the dollar has dominated the last 20+ years so everyone see adding any other currency diluting the strength of returns. No different then the guy at Enron thinking adding any other stock is only diluting his great returns.

Good luck.
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Re: Don't add currency risk on top of equity risk

Post by ohai » Wed May 22, 2019 11:18 am

Hi, OP. Here is my take on this. If you are in a major, major country, and US in particular, foreign currency exposure likely increases your risk, as you're exposing yourself to country specific issues. Since the US is such a large portion of global assets and most of the world runs on USD, your asset prices will buffer depreciation of USD to some extent.

However, if you are in a smaller country, let's say Mexico or even Canada, you have a real risk of country specific issues that could affect your cost of living. Therefore, you should hedge your local currency risk.

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Re: Don't add currency risk on top of equity risk

Post by andrew99999 » Wed May 22, 2019 11:46 am

CULater wrote:
Wed May 22, 2019 7:05 am
Since 1/16 (longest period available), the MSCI ex-U.S. ETF (ACWX) compared to the MSCI ex-U.S. currency hedged ETF (HAWX) (from Portfolio Visualizer):

CAGR 8.13 vs. 8.89
SD 11.42 vs. 10.14
Max DD -18.40 vs. -11.75
Sharpe .65 vs. .79

Clearly, currency risk has been notably negative for U.S. foreign stock investors more recently. CAGR for unhedged MSCI ex-U.S. has been 9% lower, while volatility has been 12% higher and the worst drawdown has been 57% larger. The USD has moved in waves vs. foreign developed market currencies. Given the greater volatility of foreign currencies, one should have some conviction that foreign currencies will move higher relative to the USD in order to compensate for this additional risk -- do you? Once again, this is a speculative bet and not an investment per se.
I think point 4 in the below article is relevant to these statistics.
The US had an significant bull run for quite a while, when if you look at returns to 2013 the US and ex-US seem to interweave up and down between each other over time with much less difference - then as nominal amounts are always going to be the highest at the end, the difference in returns is falsely magnified to the point of eclipsing the latest under performer (ex-US).
https://earlyretirementnow.com/2019/05/ ... l-finance/

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Re: Don't add currency risk on top of equity risk

Post by Ben Mathew » Wed May 22, 2019 12:43 pm

Over the long term, exchange rates reflect inflation rates (high inflation rates will weaken the currency). So exchange rate movements actually serve as a natural hedge against unpredictable inflation rates across countries. Allowing the exchange rate to vary will mean that the real return you get from an asset located in country X is unaffected by the inflation rate in that country. So hedging against currency risk and locking in a particular exchange rate can actually increase the risk in real terms. I sleep better at night without currency hedges on top of my international stocks.

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Re: Don't add currency risk on top of equity risk

Post by nisiprius » Wed May 22, 2019 1:10 pm

Ben Mathew wrote:
Wed May 22, 2019 12:43 pm
Over the long term, exchange rates reflect inflation rates (high inflation rates will weaken the currency). So exchange rate movements actually serve as a natural hedge against unpredictable inflation rates across countries. Allowing the exchange rate to vary will mean that the real return you get from an asset located in country X is unaffected by the inflation rate in that country. So hedging against currency risk and locking in a particular exchange rate can actually increase the risk in real terms. I sleep better at night without currency hedges on top of my international stocks.
Most things have tended to have a positive real return over long past periods, so most things would have acted as inflation hedges. Things that don't are the exception. Why is holding things that sorta-kinda-tend-to hedge inflation better than the simple direct approach of buying TIPS that are directly linked to the CPI? TIPS may have low return, but the expected return of foreign currencies is zero.
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Re: Don't add currency risk on top of equity risk

Post by willthrill81 » Wed May 22, 2019 2:00 pm

This is a noted problem with foreign investing, and the 'global market cap' advocates tend to gloss over it, claiming that it shouldn't matter over the long-term. But it is certainly an uncompensated risk. Whether the benefit of added diversification is worth it is inherently subjective, contrary to what many purport.
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Re: Don't add currency risk on top of equity risk

Post by vineviz » Wed May 22, 2019 2:09 pm

SovereignInvestor wrote:
Wed May 22, 2019 7:10 am
US Large caps like S&P are a good hedge agains the dollar with near 50% of sales coming from overseas.
Not so much, because virtually all of those revenues are hedged back to the US dollar.
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Re: Don't add currency risk on top of equity risk

Post by garlandwhizzer » Wed May 22, 2019 2:10 pm

xavierr wrote
;
In a bear market, there is a flight to quality: investors sell risky assets to buy non-risky assets. US treasuries rally and so does the US dollar. If you’re holding foreign stocks unhedged, you will lose on the stock market decline, and you will also generally lose on the currency conversion (because the US$ has appreciated and the foreign currency you are holding has depreciated). This phenomenon is well documented.
This is true. In recent years both equities and currencies in INTL and especially EM have underperformed their US counterpoints, and hedging currency risk has improved returns and reduced risk for both stocks and bonds. This however may not be a permanent situation. The only thing that is permanent in markets long term is change. The tables may turn at some point, perhaps sooner than many believe. Hedging currencies costs money particularly in EM currencies which are more volatile and over a long time frame I believe the costs will outweigh the volatility benefits, particularly if the dollar weakens. The improvement in volatility and reduced maximum drawdown from hedging is not free and may not be persistent.

Nothing reduces portfolio volatility like quality US bonds and personally that is what I count on as my anchor rather than alternates or currency hedging. I do not hold INTL bonds, only US quality bonds for this reason. In the equity space, I believe in the long run unhedged INTL equities will outperform currency hedged INTL due to decreased costs and as well it theoretically provides greater diversification to a US dominated portfolio. When the going gets tough like now with all the trade war tensions and uncertainty, Brexit, rise of populism in Europe, lack of significant economic growth in Japan and Eurozone, etc., currency hedging has looked good but that does not guarantee that this is a permanent situation going forward. It's all a matter of personal preference but that's just my point of view. Others may see it differently.

In the depths of a bear market we see no 100% equity posts on the Forum but we do see them frequently during a long bull market. Actually from a future return perspective the opposite move, increasing equity in a deep bear market and reducing equity after a long bull market, turns out to produce better risk adjusted returns. When risk is abundantly evident moves to reduce it tend to be more expensive. So it may be with currency hedging now where its risk is totally evident and therefore its costs going forward likely fully reflect that increased risk.

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Re: Don't add currency risk on top of equity risk

Post by Ben Mathew » Wed May 22, 2019 2:11 pm

nisiprius wrote:
Wed May 22, 2019 1:10 pm
Ben Mathew wrote:
Wed May 22, 2019 12:43 pm
Over the long term, exchange rates reflect inflation rates (high inflation rates will weaken the currency). So exchange rate movements actually serve as a natural hedge against unpredictable inflation rates across countries. Allowing the exchange rate to vary will mean that the real return you get from an asset located in country X is unaffected by the inflation rate in that country. So hedging against currency risk and locking in a particular exchange rate can actually increase the risk in real terms. I sleep better at night without currency hedges on top of my international stocks.
Most things tend to have a positive real return in the long run, so most things act as inflation hedges. Things that don't are the exception. Why is holding things that sorta-kinda-tend-to hedge inflation better than the simple direct approach of buying TIPS that are directly linked to the CPI? TIPS may have low return, but the expected return of foreign currencies is zero.
I think you might be misunderstanding what I'm saying. I wasn't advocating holding foreign currencies as a hedge against inflation. I was trying to say that if a person holds real foreign assets (so stocks, not bonds) without hedging for currency risk, then over the long term, they can expect to get roughly the real rate of return produced by those real assets. If instead they also buy currency futures thinking it will protect against the exchange rate risk, it can cause the real return to deviate from the real return produced by the real asset.

An example to illustrate what I'm trying to say: Suppose you have a farm in Mexico that produces 100 apples per year. An apple costs 20 Mexican pesos. So profit equals 20*100 apples = 2000 pesos. Exchange rate is 20 pesos to 1 USD, so profit in USD is 2000/20 = $100 per year.

Suppose inflation in Mexico causes the value of the peso to halve. So an apple now costs 40 pesos instead of 20. Profit in pesos doubles to 4000 pesos. But the exchange rate also doubles to 40 pesos to 1 USD. So the profit in dollars remains 4000/40= $100 per year. Same as before. So you're immune to inflation rates in Mexico. You simply collect the real value of the output of your farm, whether in USD or in pesos.

If on top of simply owning the farm, you had also bought currency futures thinking this will help you hedge against exchange rate risk, your profit will become sensitive to inflation rates in Mexico. So, not buying currency futures might be safer than buying currency futures when you're dealing with real assets. (This would not be true for nominal assets. A currency hedge will protect against unexpected inflation if you're holding mexican bonds.)

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Re: Don't add currency risk on top of equity risk

Post by CULater » Wed May 22, 2019 2:18 pm

Seems to me that people keep conflating the concepts of "diversification" with "insurance" when talking about owning currencies. As stated, there is no diversification benefit to U.S. investors from holding multiple currencies. Historically, the expected return from doing that is zero, nada, and all you get is the added portfolio volatility.

Now the notion that something adverse might happen to the USD and you'll save some bacon by holding other currencies is arguable, but that's an "insurance" argument and not a diversification argument, IMO. If you want to do that, there are better ways than owning foreign stocks because you thereby assume the risk of both the stocks and the currencies; and, as also pointed out, the equity returns can be negatively correlated to the currency returns and mitigate the benefit. I just can't see a strong case for foreign equities based on the "currency insurance" argument. Just own the currencies.
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Re: Don't add currency risk on top of equity risk

Post by vineviz » Wed May 22, 2019 2:26 pm

CULater wrote:
Wed May 22, 2019 2:18 pm
Seems to me that people keep conflating the concepts of "diversification" with "insurance" when talking about owning currencies. As stated, there is no diversification benefit to U.S. investors from holding multiple currencies.
Having a claim on cash flow steams denominated in different currencies is most certainly a form of diversification. And I've never seen any definitons of "diversification" or "insurance" that would lead me thing the distinction you are trying to draw is a material one.
CULater wrote:
Wed May 22, 2019 2:18 pm
I just can't see a strong case for foreign equities based on the "currency insurance" argument. Just own the currencies.
I don't see anyone making a case for foreign equities based SOLELY on the currency diversification benefits they offer. But since I can buy the foreign equity exposure I want and get some amount of currency diversification benefit for free, I'm pretty happy to take it.
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Re: Don't add currency risk on top of equity risk

Post by CULater » Wed May 22, 2019 2:40 pm

Having a claim on cash flow steams denominated in different currencies is most certainly a form of diversification. And I've never seen any definitons of "diversification" or "insurance" that would lead me thing the distinction you are trying to draw is a material one.
Well, on the face of it that would seem so. But if that's the case, it is diversification without any expected return benefit that increases return volatility. That's not what we think of as useful diversification, so why do it except for the argument that it hedges against the pitfalls of only owning USD denominated assets, which is an "insurance" argument. Nothing wrong with that argument, but other, perhaps better, ways to do that than owning foreign equities.
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Re: Don't add currency risk on top of equity risk

Post by asif408 » Wed May 22, 2019 3:06 pm

So OP, do you own foreign equities? And if so, why?

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Re: Don't add currency risk on top of equity risk

Post by vineviz » Wed May 22, 2019 3:17 pm

CULater wrote:
Wed May 22, 2019 2:40 pm
Having a claim on cash flow steams denominated in different currencies is most certainly a form of diversification. And I've never seen any definitons of "diversification" or "insurance" that would lead me thing the distinction you are trying to draw is a material one.
Well, on the face of it that would seem so. But if that's the case, it is diversification without any expected return benefit that increases return volatility. That's not what we think of as useful diversification . . . .
The expected return of currency exposure is generally about zero, true. Given that, any costs incurred to hedge that currency exposure are wasted: money spent with a negative ROI.

And including currency diversification in a portfolio doesn't necessarily increase the volatility of that portfolio. Depending on the amount of exposure, it could have ANY impact on volatility: increasing it, decreasing it, or leaving it unchanged.

Even with a relatively large international equity allocation, hedging the currency is unlikely to reduce the overall portfolio volatility by more than 40 or 50 bps: I know few investors who could genuinely notice that.
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Re: Don't add currency risk on top of equity risk

Post by JackoC » Wed May 22, 2019 4:18 pm

CULater wrote:
Wed May 22, 2019 8:42 am
From the Vanguard paper:
Currency has no intrinsic return, but it can add material short-term volatility, thereby introducing performance differences.
Therefore, over the long term, currency exposure adds only return volatility to an investment. Keeping that exposure means added volatility in the short term in the international asset returns, but long-term, minor and fluctuating changes in total return can be expected (Greiner, 2013).
The gist of their conclusion is that currency volatility increases portfolio volatility without adding any intrinsic return, but that over time periods of 20 years or so, this added volatility has had no predictable effect on long term returns for U.S. investors. Couple things: (1) adding currency volatility by means of unhedged foreign investments adds uncompensated return risk, especially for investment horizons that are not long, and (2) there is no evidence that adding currency exposure has actually improved portfolio returns or risk-adjusted returns even over the long run. One might conclude that currency exposure has been at best useless for U.S. investors. This is worth noting, since there is an often-made argument that currency exposure is a beneficial aspect of foreign investment for U.S. investors. The facts argue otherwise. But of course this could change in the future -- but that would be speculation and not investing.
But this is read in terms of the misconception of the nature of stock investment in a company whose stock is priced in a unit of account other than the USD. That is not 1:1 'currency exposure' the way either a currency hedge or a foreign currency denominated bond would be.

Look again to the *portfolio* impact of adding non-USD unit of account stocks to a portfolio. It's repeated in the paper you referenced as well as the one I linked. Figure 7 graphs c and d of the one you quoted
https://personal.vanguard.com/pdf/ISGPCH.pdf
The addition of an unhedged % of non-US stocks to a portfolio *decreased* the portfolio volatility up to around 40% foreign in the historical data set Vanguard used. Their comparison just shows that putting on currency hedges for 30% or 100% of the value of the foreign stocks *further* reduced the portfolio volatility in that data set. But then the paper goes into various nuances of why they still don't view currency hedging of foreign stock favorably (something the Vanguard all-in-one funds don't do, they hedge foreign currency bonds but not foreign company stocks).

And in general it would be strange if Vanguard published a bunch of papers on non-US stock investing which concluded it just added 'uncompensated risk', then went ahead over the same period *increasing* the non US % in the all-in-one funds. Vang's particular policy of having, and changing (less than very rarely) those allocations can be debated. But it's pretty clear Vang's position is not as you imply. :happy

As to 'speculation', unfortunately it's just as speculative to assume the future will the same as the past as to assume it will be different. 'The facts' say nothing definitive on most questions about the future risk and return, and the risk effect of adding foreign stocks is not an exception to the rule. The only things you can assume about the future are those which are axiomatic. For example, it's axiomatic that all investors combined get the market return minus average expenses, so on average investors who play the market but pay above average expenses will get a lower net return than investors who lock in the average return but pay below average expenses (via low cost index funds). It's near axiomatic that holding a single stock even at zero cost will have more risk without more return than holding cap weight among 1000 stocks in an index fund even with small costs. But again unfortunately there is no basic principal by which non-US stocks add or subtract std deviation of return at any given % weighting for a USD unit of account investor. Foreign stocks slightly decreased risk up to 40% foreign among stocks in Vanguard's data set in those papers, so it's misquoting them to say the opposite, but that's an empirical result for the past. There's no 'first principal' which says it would always be true or not.

Diversifying internationally however is clearly, well, diversifying, against things like possible valuation excesses in one market (Nikkei investors would have benefited since the 1980's for example), or changes in the fortunes of particular sectors over or underrepresented in one country or another, for example tech now so heavily represented in US indices, heavy industry relatively underrepresented. IOW there are reasons for international diversification which go beyond chewing over past data sets.

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Re: Don't add currency risk on top of equity risk

Post by wwtas » Wed May 22, 2019 4:39 pm

Doesn't currency hedging mean one is not holding a (supposedly) efficient market portfolio anymore? If the goal is to hold a global market cap weighted (or in case of two stock funds, non-US market cap weighted) fund, then currency shouldn't matter. To get the proper market cap ratios between different assets, values have to be converted to one currency. The result should be same irrespective of currency (it could even all be expressed in terms of gold for example...). Adding hedging for all local currencies seems complicated and artificially increases exposure to health of a single currency. Maybe USD is safe enough but who knows. Am I missing something?

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Re: Don't add currency risk on top of equity risk

Post by 3funder » Thu May 23, 2019 7:53 am

Thesaints wrote:
Tue May 21, 2019 7:33 pm
Over the long term, volatility introduced by currency exchange fluctuations is small compared to the natural volatility of stocks.
The story is different for bonds.
+1.

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Re: Don't add currency risk on top of equity risk

Post by CULater » Thu May 23, 2019 9:31 am

I believe the correct way to view currency risk (FX - foreign exchange risk) as a standalone "asset" in one's portfolio. One can then examine this portfolio asset for it's expected return and correlation to other assets in the portfolio. When viewed this way, we see that FX risk has a zero expected return (it is uncompensated) and a low correlation overall with other assets such as the global stock market. One has to ask if the benefit of including this asset in one's portfolio outweighs the opportunity cost of not including it. Viewed in this manner, FX risk can be compared to other risks with similar characteristics. I believe that it is not a particularly useful asset - no more useful than dedicating a portion of one's portfolio to a coin toss every so often, which also has a zero expected return and a low correlation to other portfolio assets. In effect, choosing to not currency hedge one's foreign investments is a decision to accept FX risk as a portfolio "asset." For U.S. investors, this has not proved to be of historical benefit. But if one has some insight into the future movements of international currencies (has an "edge" on the house), it might make some sense going forward.
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Re: Don't add currency risk on top of equity risk

Post by vineviz » Thu May 23, 2019 12:21 pm

CULater wrote:
Thu May 23, 2019 9:31 am
I believe the correct way to view currency risk (FX - foreign exchange risk) as a standalone "asset" in one's portfolio. One can then examine this portfolio asset for it's expected return and correlation to other assets in the portfolio.
Except it's not a "standalone asset" in this context: it's embedded in another asset (i.e. ex-US stocks) by default.

Accepting the embedded risk requires no allocation of capital whereas hedging the risk DOES require the allocation of capital. For most assets, the investor must decide whether to allocate capital to a risk in order to gain exposure to it. Not so in this case: once a US investor has decided to invest in non-US stocks, they get the currency exposure "for free".

In order to hedge away that risk, they'd have to sell some ACTUAL asset in order to fund futures, options, or swaps needed to create the hedge. The question then becomes either:

A) should the investor forgo the international equities in order to avoid the currency exposure?

or

B) should the investor reduce their equity and/or fixed income holdings in order to purchase a currency hedge?

For the vast majority of investors, the only rational answer is "no" to both questions. Both "solutions" reduce the expected return of the portfolio without creating a meaningful correspondent reduction in volatility and reduce the diversification of the portfolio.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Don't add currency risk on top of equity risk

Post by CULater » Thu May 23, 2019 12:36 pm

vineviz wrote:
Thu May 23, 2019 12:21 pm
CULater wrote:
Thu May 23, 2019 9:31 am
I believe the correct way to view currency risk (FX - foreign exchange risk) as a standalone "asset" in one's portfolio. One can then examine this portfolio asset for it's expected return and correlation to other assets in the portfolio.
Except it's not a "standalone asset" in this context: it's embedded in another asset (i.e. ex-US stocks) by default.

Accepting the embedded risk requires no allocation of capital whereas hedging the risk DOES require the allocation of capital. For most assets, the investor must decide whether to allocate capital to a risk in order to gain exposure to it. Not so in this case: once a US investor has decided to invest in non-US stocks, they get the currency exposure "for free".

In order to hedge away that risk, they'd have to sell some ACTUAL asset in order to fund futures, options, or swaps needed to create the hedge. The question then becomes either:

A) should the investor forgo the international equities in order to avoid the currency exposure?

or

B) should the investor reduce their equity and/or fixed income holdings in order to purchase a currency hedge?

For the vast majority of investors, the only rational answer is "no" to both questions. Both "solutions" reduce the expected return of the portfolio without creating a meaningful correspondent reduction in volatility and reduce the diversification of the portfolio.
Currency risk is embedded in foreign equity risk only by choice -- the choice not to hedge. The capital required to hedge nowadays is very low, even negligible, because interest rates have been pegged near zero. One needs to be clear about the current cost of currency hedging if done by a fund or ETF. Wisdomtree uses currency hedging and estimates their cost of hedging as only 2 to 3 basis points per year -- hardly a massive reallocation of one's capital. If interest rates were high, it would be less advantageous. The essential choice one is making is to accept active currency risk or not.
Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith

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Re: Don't add currency risk on top of equity risk

Post by vineviz » Thu May 23, 2019 12:45 pm

CULater wrote:
Thu May 23, 2019 12:36 pm
The essential choice one is making is to accept active currency risk or not.
Clearly you have strong opinions on this, and some observers are undoubtedly viewing this a semantic distinction, but once the investor has decided to invest international stocks the only additional choice they must make is whether they want to take action to remove some or all of the embedded currency exposure.

Taking action means removing it, and I think understanding this distinction is the key to making an intelligent decision about it.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Don't add currency risk on top of equity risk

Post by CULater » Thu May 23, 2019 1:08 pm

vineviz wrote:
Thu May 23, 2019 12:45 pm
CULater wrote:
Thu May 23, 2019 12:36 pm
The essential choice one is making is to accept active currency risk or not.
Clearly you have strong opinions on this, and some observers are undoubtedly viewing this a semantic distinction, but once the investor has decided to invest international stocks the only additional choice they must make is whether they want to take action to remove some or all of the embedded currency exposure.

Taking action means removing it, and I think understanding this distinction is the key to making an intelligent decision about it.
It's not complicated. The only action they have to take is to own a fund or ETF that uses currency hedging. It is a passive strategy. It is certainly a debatable issue, but I think that investors need to be aware that they are adding embedded FX or currency risk to their portfolios with plain-vanilla foreign equities and make a conscious decision about whether they want to do that. It may be "free" but its certainly not a "free lunch" to do that, IMO.

As I said, I don't believe that it is valid to assert that FX risk is a diversifying asset -- it does nothing to diversify one's portfolio in a useful manner because the expected return is zero and it adds volatility.

Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith
Faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith

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Re: Don't add currency risk on top of equity risk

Post by vineviz » Thu May 23, 2019 1:12 pm

CULater wrote:
Thu May 23, 2019 1:08 pm
As I said, I don't believe that it is valid to assert that FX risk is a diversifying asset -- it does nothing to diversify one's portfolio in a useful manner because the expected return is zero and it adds volatility.
Your belief may very well be based on a misunderstanding of how diversification works, because neither an expected return of zero nor the presence of volatility would prevent an asset from contributing to the diversification of a portfolio.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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