When exchange rate volatility takes a bite out of your portfolio, should you change your strategy or hedge your bets? This month we take a look at short and longer-term currency trends and offer our advice on what to do (and what not to do). As always, diversification is your strongest ally.
February was a strong month for U.S. stocks. Recovering from last month's decline, the S&P 500 index returned 5.75%, the MidCap 400 index returned 5.12%, and the SmallCap 600 index returned 6%. February’s rebound raised YTD returns to 2.57% for the S&P 500, 3.94% for the Mid Cap index, and 2.32% for the Small Cap index.
Outside the U.S., developed markets (MSCI EAFE index) returned 5.98%. Within the developed markets, the MSCI European index returned 6.28%, the Japanese Large Cap index returned 8.55% and the Pacific ex Japan Index returned 4.51%. Developing markets lagged developed markets, but the MSCI Emerging Markets did well, returning 3.10% for the month. YTD, global stock markets (MSCI World Index) returned 3.94%. Excluding the U.S., global stock markets (MSCI All Country World ex USA index) returned a healthier 5.19% YTD.
U.S. interest rates increased across the board, leading to a 1% decline for the S&P U.S. Aggregate Bond index. The S&P/BG Cantor 7-10 Year U.S. Treasury Bond Index declined 2%. The S&P National AMT Muni Bond index fell 1%. A plunge in gas prices lowered consumer prices 0.1%, the most in six years. The core U.S. consumer price inflation index rose 0.2%.
The Dow Jones Commodity Index and the S&P GSCI gained 3% and 6%, respectively. Bucking the recent trend, the Energy sector ended the month up 11%. Gold shares fell 3.7%.
INTERNATIONAL DIVERSIFICATION AND CURRENCY VOLATILITY
It’s undeniable that in the short run, exchange rate volatility has had a large impact on U.S.-dollar denominated returns of foreign assets. The numbers above tell the story: the S&P returned 2.57% YTD compared to more than double that for the MSCI EAFE index. The trailing 12-month return for MSCI’s EAFE Index in U.S. dollar terms was negative -0.03% versus a generous 15.63% return when measured in local currencies.
But over longer periods of time, the currency impact tends to be muted: the trailing 10-year annualized return for the EAFE index was 4.84% in U.S. dollars compared to 5.91% in local currencies.
As investors increased their exposure to foreign equities over the past few decades, their interest in currency fluctuations has grown. All else being equal, foreign equities appear more attractive to U.S. investors when the dollar is appreciating, and less attractive when the dollar is depreciating. In an effort to boost returns, some try to tactically neutralize their foreign currency exposure. Others adjust their domestic and foreign equity allocations.
Neither of these approaches is a good idea. First, there is no reliable model for predicting currency exchange fluctuations. Exchange rates are an asset price just like equities, and are virtually impossible to predict in the short and intermediate terms. And second, trying to time different equity sectors is never a smart idea. Being “in” or “out” of certain market sectors decreases portfolio diversification and adds risk. Consider this data:
• Between 2001 and 2014, the investor who was fully diversified across U.S. equities, international equities, emerging market equities and real estate securities (DFA Global Equity Balanced Index) outperformed the S&P 500 investor by more than 4% annually.
• This outperformance happened despite the fact that from 2008 to 2014, the S&P 500 outperformed the MSCI World ex USA Index by 7.6% per year. Of course, from 2001 to 2007, U.S. equities underperformed non-U.S. equities by over 5%. The investor who ignored these swings and remained diversified over the entire period of time outperformed both indexes by 4% annually.
As always, Cardiff Park advocates holding a diversified portfolio to minimize the risk of underperformance. Avoid the temptation to try and beat the market and currency fluctuations. Don’t look in the rear view mirror at what did well, or place bets on what you believe will happen next.
What’s the best way for investors to deal with volatility in exchange rates? Simply ignore the noise. Focus instead on what you can control: namely, a sound investment philosophy, a disciplined approach, broad diversification, minimizing taxes, reducing expenses, and allocating assets based on your own unique needs and preferences.
Bottom line: control what you can, take a long-term view, and let the markets do their work.
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