To Hedge or Not to Hedge: The Slings and Arrows of Currency Risk in Minimum-Volatility Investing

Abstract

We found that it is important to address currency risk to take full advantage of the benefits of minimum-volatility investing. In our backtest that extended back to 1979, we found that hedging currency risk would have led to a higher Sharpe ratio by decreasing risk while maintaining return at a similar level. In the absence of hedging, a minimum-volatility portfolio’s currency risk creates a home bias and other distortions. Separating equity selection from currency risk built a portfolio that is low risk from a local-currency perspective. This local-currency portfolio historically delivered higher risk-adjusted returns which we attribute to better stock selection. We found this result to be consistent for multiple investor domiciles including the United States, Great Britain, Germany, Japan, and Australia. As a bonus, the hedged portfolio’s return was also less correlated with the global equity market, making it a better portfolio diversifier. To our knowledge, despite extensive research published on low-volatility investing, currency-related issues have not yet been reported on.

Keywords: minimum volatility investing, global equities, currency risk, currency hedging

JEL Classification: G12, G15