While there may be no place like home, when it comes to investing, it can pay to be something of a world traveller. At least that’s what research into the phenomenon of “home bias” in investing – that is, the over-reliance on securities from an investor’s domestic market – has consistently shown. Compared to geographically diversified portfolios, portfolios with a clear “home bias” almost always underperform.
It is not difficult to see why. Looking abroad for opportunities allows investors to take advantage of benign economic cycles in other parts of the world, perhaps mitigating the effects of a slowdown at home. It provides a much larger investment universe, opening up new opportunities. By increasing diversification, it also reduces risk.
These are all highly desirable effects. Yet, while the benefits of global diversification are clear, it does expose investors to one major risk they do not face at home: adverse currency movements. In today’s volatile foreign exchange environment, it is a risk that should not be underestimated.
Currency-hedged ETFs: best of both worlds
So how can investors reap the benefits of global diversification while avoiding currency pitfalls? The answer lies in hedging.
By adding a currency hedge to a trade, investors can neutralize the effects of currency movements on their positions. That means they don’t lose out when currencies move against them (it also means they don’t win when currencies move in their favor).
While hedging can be complex, the advent of currency-hedged ETFs has made it very easy for index investors to reap its benefits. A currency-hedged ETF is nothing other than a standard ETF with a currency hedge built in. With it, an investor can get exposure to foreign markets as if they were in his or her own home currency. The risk of foreign exchange loss is eliminated.
With currency-hedged ETFs available for equity, fixed income as well as commodities and other asset classes, today’s index investor has the freedom to build a truly global, diversified and liquid portfolio without worrying about what currency markets might do.
Why stay at home?