Stocks, Bonds, Gold: Hedge the Currency or Not?

A share from Switzerland, a Japanese bond, gold in dollars – when investors put their assets in foreign investments, their value is also exposed to fluctuations in exchange rates. Shijiao You, Sebastian Dörr and Pascal Kielkopf have investigated whether it can make sense for investors to hedge the associated risks.

If the famous crystal ball existed and investors knew which asset class would perform best, broad diversification would be unnecessary. They could simply buy the top stock or bond and watch it rise. As we all know, the reality is different. It is by no means certain which investment will perform best in the weeks or months ahead: Stocks or bonds? Large or small companies? Dax or S&P? Or even gold in the end?

The best way to counter this uncertainty is broad diversification: investors do not just focus on one company, one sector or one asset class, but invest their capital in a variety of ways: in stocks from different countries and sectors, in different bonds and precious metals. In addition, there may be so-called alternative investments, i.e. asset classes such as private equity, real estate or infrastructure.

However, this undoubtedly sensible diversification raises a new question: Should currency risks be hedged? After all, if investors put their assets in foreign investments such as Swiss equities, U.S. bonds or gold quoted in U.S. dollars, their value is also exposed to fluctuations in exchange rates. Capital market analysts Shijiao You, Sebastian Dörr and Pascal Kielkopf have investigated whether it can make sense for investors to hedge these risks. In this article, they limit themselves to the so-called liquid asset classes equities, bonds and the precious metal gold.

Does it make sense to hedge global equity investments against currency fluctuations?

Pascal Kielkopf has investigated whether, from the point of view of a euro investor, it would have been better over the past 25 years to hedge global equity investments against currency fluctuations or to leave currency risks unhedged. To this end, he compared the fluctuations and returns of the MSCI World stock index with its hedged variant, the MSCI World Euro Hedged, for the period from 1999 to the present.

The result: In the long term, hedging the currency risk would not have been worthwhile. In terms of volatility risk, the two variants were roughly on a par: while the MSCI World had an average volatility of 14.4 percent, the currency-hedged variant had an average volatility of 14.5 percent per year over the long period.
Hedging would not have been beneficial in terms of returns either: since the beginning of 1999, the MSCI World price index has gained an average of 3.8 percent per year. By contrast, the hedged version of the MSCI World only managed a gain of 2.9 percent per year over the same period.

But that doesn’t mean hedging never made sense: Over shorter periods, currency hedging would have paid off again and again, for example when the tech bubble burst in the early 2000s or during the financial crisis in 2007 and 2008. Over the longer term, however, currency movements usually cancel each other out, so performance is worse after costs are deducted.

Can bond investors sleep soundly without currency hedging?

Bonds are known to serve as a safe haven in the portfolio and help reduce risk in the portfolio. However, investors had to learn that they do not always live up to this function, especially in the historically bad investment year of 2022. Sebastian Dörr’s study shows that such fluctuations are not unusual in global bond investments without currency hedging.

The capital market analyst calculated the return and volatility of the Bloomberg Global Aggregate global bond index and compared it with the values of the currency-hedged variant: Would bond investors have been able to sleep soundly in the period since 1999 even without currency hedging?

The result of this analysis is different from that of equities: Especially in the fluctuations, which Sebastian Dörr calculated using the so-called rolling 12-month volatility, the differences were enormous. Without currency hedging, fixed-income securities sometimes reached volatilities reminiscent of stocks. At its peak, the “vola” was more than 11%. With currency hedging, on the other hand, this risk ratio was usually only between 2% and 4%.

Investors would have had to pay for this much quieter sleep with a minimal performance disadvantage over the entire period: With the hedged variant, the return since 1999 would have been 2.99% p.a., without hedging it would have been 3.07% per year – whereby investors in both cases would have more than doubled their capital despite the bad bond year 2022.

Is currency hedging worthwhile for gold investments?

The U.S. dollar represents the primary currency for commodity trading, and accordingly the price of gold is also primarily priced in this currency. Changes in the gold price and the dollar are caused by a variety of factors, including interest rates and fears of currency devaluation. But an important aspect is also the interaction between gold demand and currency valuations.

Shijiao You examined how the gold price and the euro/dollar currency pair developed in the past and calculated the rolling 52-week correlations from January 1999 to the end of June 2023. The result may surprise many investors: Over the past 25 years or so, there has always been a negative correlation between the U.S. dollar and the U.S. dollar price of gold. This means that the gold price tended to fall when the dollar strengthened – and vice versa.

What does this mean in terms of possible currency hedges for gold investments and how can investors profit from this negative correlation? Since a weak gold price tends to be accompanied by a stronger dollar against the euro, currency gains offset some of the gold price losses. In times of a rising gold price, the euro, which then tends to be stronger, has a braking effect, but in the long run the currency effects often balance each other out.

The bottom line is that the negative correlation also ensures that the volatility of the gold price is lower for euro investors, while no major differences in returns are to be expected in the long term. An investment in gold would have given euro investors an average annual return of 8.4% since 1999. In U.S. dollars, it would have been 8.0% p.a. From this it can also be deduced that currency hedging is not worthwhile for gold investments.

Summary and conclusion

In a constantly changing financial world with many external influencing factors, a broad diversification of investments remains the best strategy for reducing risk. Since investors cannot reliably predict which asset class will perform best in the future, diversification across many different asset classes promises the best success.

The question of hedging currency risks depends above all on the volatility of the asset class in question. The research makes clear that for investments in global equities or gold, the volatility risk is hardly changed by foreign currencies. However, the analysis has shown that global bonds only fulfill their function as an anchor of stability if the currency risks are hedged, as the currency effects significantly increase the fluctuation risk.