Currency and inflation hedges don't pay off in the very long term, report finds

In the very long run, neither currency hedging nor inflation hedging pays off for investors' returns, according to an annual report by the London Business School and Credit Suisse.

For investors in most countries, the impact of currency changes over the past 113 years has been “modest,” and currency in real terms (adjusted for purchasing power) has been fairly consistent over the period, according to the Credit Suisse Global Investment Returns Yearbook 2012 by Elroy Dimson, Paul Marsh and Mike Staunton. Messrs. Dimson and Marsh are emeritus finance professors at London Business School, while Mr. Staunton is director of the school's London Share Price Database.

Meanwhile, few assets effectively hedge inflation, and the one that does — indexed-linked government bonds — offered negative yields in the U.S., U.K. and Canada as of Dec. 31.

“If we want to hedge ourselves against inflation, we will get a poor return for that,” Mr. Dimson said at a Feb. 7 news conference in London.

Currency movements can be significant and hedging decisions can be meaningful, the professors said. During the 40-year period ended Dec. 31 (the post-Bretton Woods era), U.S. investors would have benefited from not hedging. Annualized equity returns of 6.1% were boosted 140 basis points annually by not hedging equities, while bond returns of 4.6% benefited from a 150-basis-point fillip.

While currency hedging might be effective over shorter periods, across all countries it's a zero-sum game, the yearbook authors state. That is, currency movements that boost returns on U.S. investors' European holdings similarly reduce Europeans' U.S. investment returns.

“Don't think of (currency) hedging as something you do to enhance returns; it's something you do to decrease risk,” Mr. Marsh said at the news conference.

Currency risks present a much greater danger to bond returns than to stocks. Investors holding global stocks for the 40 years ended Dec. 31 would have seen on average a 20% risk reduction from geographic diversification, outweighing the 7% risk reduction from currency hedging.

However, it's a different story for bonds. Investing globally over the past 40 years would have increased risk by 35%, while currency hedging would deliver a 30% risk reduction.

“For bonds, you can see there's a compelling case for hedging out currency risks,” Mr. Marsh said. While investing globally in bonds “gives you some diversification benefits … currency risk wins on the bond side.”

But even within bonds, the risk-reducing power of hedging declines as the horizon of the hedge is extended. The 30% risk reduction for a one-year period falls to less than 25% for a four-year period and turns negative over an eight-year period, according to the report.

Looking at periods of inflation and deflation in 19 countries over the 40 years ended Dec. 31, the professors found that equities outperformed inflation in the long run, but offered poor hedging characteristics. “That is, when inflation jumps up, there's no indication that equity returns go up,” Mr. Dimson explained.

Real equity returns weren't significantly affected by deflation, but as inflation rises, real equity returns decline, according to the report. Looking at inflation levels each year in each country gave the researchers 2,128 country-years of data. In the 5% of cases of the highest inflation — an average of 18% — real equity returns were -12% vs. 11.9% when inflation averaged -3.5%.

The effect holds for bonds, except that bond returns spike in extreme deflationary environments.

The professors also found that gold returns were too volatile to be a reliable hedge, and that real estate returns were less hurt by inflation than stocks or bonds, but that it “has to be considered as a long-term commitment (and not one) that should be initiated because of a new concern about inflation risk.”