How Currency Hedging Works - Forwards and Hedging Costs
Currency hedging is a technique that offsets the exchange rate fluctuation risk of overseas assets through forward contracts or swap transactions. For example, when a US equity fund hedges its currency exposure, the fund enters into a forward contract to sell dollars and buy yen at a specified future date against its dollar-denominated holdings. This means that even if the USD/JPY rate fluctuates, the yen-denominated return is largely insulated from currency movements. The hedging cost is primarily determined by the short-term interest rate differential between the two countries; when the US-Japan rate differential is 4%, an annual cost of approximately 4% is incurred.
Hedging costs are not fixed - they fluctuate significantly with the interest rate environment. During the 2010s when the US-Japan interest rate differential was small, hedging costs were below 1%, but during the US rate-hiking cycle of 2023-2024, they approached 5%. This cost variability directly affects the effective return of currency-hedged products, making it a critical factor in investment decisions.
Hedged vs. Unhedged - Historical Performance Comparison
Looking at data over the past 20 years, the performance difference between hedged and unhedged depends heavily on the investment period and currency trends. During the yen depreciation trend from 2012 to 2024 (from the 80-yen range to the 150-yen range), unhedged international equity funds significantly outperformed their hedged counterparts. Conversely, during the yen appreciation phase from 2007 to 2012 (from the 120-yen range to the 80-yen range), hedged products had the advantage.Books on currency and investment performance contain analysis based on long-term data.
Currency Strategy Based on Investment Horizon and Risk Tolerance
The choice of currency strategy varies depending on your investment horizon and risk tolerance. For short-term investments of less than five years, currency fluctuations account for a large proportion of returns, making hedged products advantageous in terms of stability. For long-term investments of 20 years or more, exchange rates tend to converge toward purchasing power parity, and it is considered more rational to go unhedged rather than continuously paying hedging costs. As a compromise, a '50:50 strategy' - holding half the portfolio in hedged and half in unhedged products - is also a practical option.
There is no single correct answer for currency strategy; the key is to make flexible decisions based on your own investment objectives and market conditions.Practical books on currency strategy and long-term investing can also help with strategy formulation.
Next Steps for Determining Your Currency Strategy
To determine your currency strategy, start by taking stock of the currency exposure of your overseas assets. Calculate the total value of assets affected by currency fluctuations - international equity funds, international bond funds, foreign currency deposits, etc. - and check what proportion they represent of your overall portfolio. If this proportion exceeds 50%, currency fluctuations will have a significant impact on your overall portfolio returns, making the consideration of a hedging strategy particularly important.
As a concrete action, you can gradually adjust your currency risk by switching a portion of your currently unhedged international funds to hedged funds tracking the same index. For example, holding eMAXIS Slim Developed Market Equity (unhedged) and eMAXIS Slim Developed Market Equity (currency hedged) in a 50:50 ratio is a practical approach that neutralizes risk without betting on the direction of currency movements. If your investment horizon is 20 years or more, lean toward a higher unhedged ratio; if it is less than 10 years, lean toward a higher hedged ratio - that is the fundamental framework.