- The continuing strength of the dollar deserves attention in determining portfolio exposures
- The dollar cycle tends to be long term, and investors need to consider their investment time horizons
- The typical international fund could see a noticeable negative impact from a strengthening dollar
The strength of the dollar, which has risen to new multi-year highs in early 2017, combined with an uncertain outlook for many international markets, give investors reason to pause and consider how best to move forward with a non-U.S. allocation.
Dollar cycles have historically lasted long periods
Beaudry emphasizes that exchange rate cycles tend to be long term, and longer than many investors realize. Since the late 1970s, the typical length of a dollar strengthening or weakening phase has been five years or more, with a full cycle lasting about 10 years. The implication is that, while U.S.-based investors might choose to hedge dollar risk, hedging is less necessary for investors with longer horizons, such as retirement investors.
How dollar cycles can influence hedging strategies
Chart 1 makes a few things apparent. First, there is a clear tendency for the performance difference to revert to the mean. As a result, arguably, decades-long hedging has a minimal impact. Second, there are substantial periods of time in which there are clear performance differences between an unhedged and a hedged investment in the MSCI EAFE Index. In many cases the performance difference can be as large as +/– 5%–10%.
Impact of the U.S. dollar on international fund performance
To better understand this relationship, we built a sample of every international equity fund that had at least $50M in assets under management (AUM) and 60 months of history, and was categorized by Morningstar as either a Foreign Large Blend, Foreign Large Growth, or Foreign Large Value fund. This yielded a sample of 1,305 funds. Next, looking at the past 60 months through 2016, we regressed the returns of each fund in the sample versus a multi-factor model, controlling for equity risk, interest rates, and the U.S. dollar.
The results confirmed the negative relationship has persisted over the past 5 years, with the average fund in the sample having a beta* of -0.90 to the U.S. dollar.† In other words, for every 1% change in the value of the dollar, the average international equity manager could move in the opposite direction by 0.9%, or 90 basis points.
Next, to get a better sense of the distribution betas to the U.S. dollar (see Chart 2), we sorted the funds in the sample by decile. We find that approximately 95% of the funds in the sample have a value that is more negative than -0.65. This means that for the vast majority of these funds, investors are indirectly betting against the U.S. dollar.
Consider currency risk in the short or intermediate term
* Beta measures volatility in relation to the fund's benchmark. A beta of less than 1.0 indicates lower volatility; a beta of more than 1.0, higher volatility than the benchmark. It is a historical measure of the variability of return earned by an investment portfolio. For fixed-income and equity funds, risk statistics are measured using a 3- and 5-year regression analysis, respectively. For funds with shorter track records, "since inception" analysis is used.
† Source: Putnam Investments. Our analysis considered the Morningstar universe of Foreign Large Blend, Value, and Growth funds, with at least $50M in assets under management and five years of history, which produced a sample of 1,305 funds. Multivariate (three-factor) regression was run over the past five years as of December 2016, controlling for equity (MSCI EAFE Index in local currency), duration (Bloomberg Barclays U.S. Treasury 7–10 Year Treasury Index) and currency (U.S. Dollar Index). MSCI EAFE Index is an unmanaged index of equity securities from developed countries in Western Europe, the Far East, and Australasia. You cannot invest directly in an index.
For informational purposes only. Not an investment recommendation.
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
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