Cash flows for mutual funds and exchange-traded funds appear to confirm that investors are still engaged in bad-for-their-wealth behavior--moving in and out of funds at the wrong time. While there is a smorgasbord of strategies available to examine, the detrimental impact of timing one's exposure to a given asset is particularly noticeable among funds that hedge their currency risk.
The primary objective of currency-hedged strategies is to eliminate currency risk from their foreign stock or bond exposures--the additional volatility that comes from changes in foreign-exchange rates. For long-term investors this is a reasonable strategy, as currency risk typically isn't compensated. But a closer look at currency-hedged funds shows that these strategies hang an enticing carrot in front of those willing to speculate. And investors, collectively, haven't been able to time currency fluctuations using these funds.
The Nature of Foreign-Exchange Risk
The volatility of foreign stocks (as measured by standard deviation) has two sources: the first being the volatility of stocks denominated in their local currency, and the second stemming from changes in the foreign-exchange rate between a stock's home currency and an investor's local currency. Strategies that hedge currency risk attempt to eliminate this second source of volatility. Theoretically, currency movements tend to be cyclical. Therefore, they can add to the long-term volatility of foreign investments without providing any compensation to investors for assuming this risk. A hedged strategy can all but eliminate this additional risk without affecting long-term returns.
