# Wary of buying international stocks? At least you no longer need to worry about hedging

New research, however, finds that for long-term investors, the impact of exchange-rate fluctuations will be minor. The research appears in Credit Suisse’s Global Investment Returns Yearbook 2021, written by Elroy Dimson, a finance professor at Cambridge University; Paul Marsh, a finance professor at the London Business School; and Mike Staunton, director of that institution’s London Share Price Database.

The reason currency fluctuations are not a big concern over the longer term, the researchers report, is that those fluctuations are inversely correlated with inflation. The countries whose currencies are strongest over time will be those with the lowest inflation rates, just as those with the weakest currencies will be those experiencing hyperinflation. The impacts of inflation and currency fluctuations will therefore largely cancel each other out, leaving little net impact over the long term.

This certainly was the case in Argentina in 2020. Its government reported that its inflation last year was 36.1%, which is 34.8 percentage points higher than U.S. inflation. Notice that the decline in the value of the Argentinian peso, relative to the U.S., was the same order of magnitude.

Big fallacy

The reason that investors in the past overlooked what the researchers have now found: Investors all too often make the mistake of focusing on nominal rather than inflation-adjusted (or real) returns. Once we focus on real returns, as indeed is appropriate, then little additional adjustment is necessary for currency fluctuations.

The researchers show this by constructing two rankings of the long-term real returns of 21 developed countries’ stock markets. One is in local-currency terms and the other is in U.S. dollar terms. Believe it or not, the two rankings are almost identical. In no event did adjusting for exchange-rate fluctuations add or subtract more than 1 annualized percentage point.

To be sure, currency fluctuations over the short term are not always perfectly correlated with relative inflation rates. We saw this in Argentina’s case last year, by the way: The decline in the value of the Argentinian peso relative to the U.S. dollar was close but not exactly equal to the difference in the two countries’ inflation rates.

If such short-term deviations create intolerable risk, then currency hedging may be appropriate. But notice carefully that past deviations have almost always corrected themselves — and usually quite quickly. So the benefits of hedging quickly decline with holding period.

High cost of hedging

Notice, furthermore, that hedging isn’t cheap. So at the same time as the benefits of currency hedging are declining, the costs associated with that hedging will be mounting. You may quickly find yourself worse off than if you hadn’t hedged. This is why the researchers suggest that the long-term investor in most cases need not worry about hedging currency risks.

This isn’t to say that international stocks aren’t risky, by the way. When judged by the volatility of annual returns since 1970 for the S&P 500 and MSCI’s EAFE indexes, international stocks are about 25% more risky. But the implication of this new research is that this additional risk does not trace to currency fluctuations. As a result, you can reduce risk more by diversifying widely among international stocks than by currency hedging.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].