Humans are funny animals. There are many events, experiences, environments, and data points in the world shaping our perception. There is a psychological phenomenon called the recency effect, although it is known in the investment world as recency bias. Without delving into the psychological science as to why this happens, I think you will agree that most people tend to place a greater emphasis on more recent events.
Another human cognitive bias is known as the bandwagon effect. As you have probably surmised, it is the tendency for a person to do things because many others are doing it. This is also called groupthink, herd mentality, or typical teenager rationalization. There are literally dozens of researched cognitive biases, and interesting things can happen when multiple ones come into play simultaneously.
I’ve seen these biases crop up in different ways when it comes to the stock market. Once a trend has been in place for about three years or more, investors start to put a much lower emphasis on the alternative trend and the implications it brings. One example is the US stock market, which has been moving in a favorable direction for nearly six years. If you were to question an investor about their tolerance for risk, I bet you will get a much different answer today than you would have in 2008 during the throes of the financial crisis.
One of the current trends in the market is the strength of the US Dollar. Currency fluctuations are nothing new. Investors buying and selling foreign mutual funds have been generally aware that currency translations will affect their returns. However, it has been more of a tacit acknowledgement as opposed to something they could manage. Unless you were a currency trader or a multi-national corporation hedging your foreign earnings exposure, you had to accept the positive and negative currency contributions of your international investments once they were converted back into US Dollars.
Ten years ago, if the news reported that the Japanese Yen was down 1% against the US Dollar, most US retail investors would be hard-pressed to tell you if that helped or hurt the return of their Japanese mutual fund. A simple way to approach this is to know the performance of a traditional foreign investment fund is the additive combination of both the country’s stock price and its currency strength. For example, if Japanese stocks were up 3% and the Yen was up 1%, then a US-based investor would see a return of 4%. However, using the example we started with of the Yen falling 1%, the fund investor would only net a 2% return (3% stock gain minus the 1% currency loss).
Enter the currency-hedged fund. A few years ago, fund sponsors began introducing explicit currency-hedged international funds. Their investment approach is straightforward; buy the stocks of the target country using the local currency, then sell that currency short against the US Dollar. The net effect is that a US investor receives only the return of the foreign stocks. Currency translation is no longer part of the equation.
One of the earliest funds using this approach came out in 2006 and targeted Japanese stocks. The fund had lackluster performance during its first five years and didn’t attract much attention. One reason was many investors did not understand the product. However, the primary reason few people wanted to invest in it (or even learn about it) was the fact that the Yen was increasing in value against the Dollar during those five years, and the fund’s currency hedging backfired. Instead of capturing the 50% rise in the Yen, this currency-hedged fund received no currency boost and lagged behind its non-hedged peers. Thanks to recency bias, this episode has been nearly forgotten.
The Yen peaked in late 2011 and has been falling ever since. That same currency-hedged fund is now going gangbusters. Its success has spawned numerous imitators, and there are now currency-hedged funds targeting many single countries, Europe, all of the emerging markets, and more. These funds pulled in more assets than most fund categories last year and another $20 billion already in 2015.
In my opinion, there are three potential problems with this. First, the US Dollar has been increasing in strength against the Yen for the past three years, against the Euro for almost seven years, and nearly every other currency for a year or more. These trends have accelerated in the past six months. Recency bias could leave investors believing a strengthening Dollar trend could remain in place for years to come.
The second potential problem is the bandwagon effect. It is already occurring in the proliferation of new currency-hedged funds and their massive inflows. The magnitude of new money coming into these funds suggests it is not just tactical traders taking advantage of current trends. Instead, these flows have the appearance of strategic asset allocators abandoning traditional international funds in favor of currency-hedged funds. This bandwagon is in an early phase, but it is already quite massive.
The third potential problem is that currency-hedged funds are relatively new products. I am not saying they are poorly constructed or untested. Just the opposite, I believe the fund sponsors are very good at this, and the products have and will perform as advertised. The problem is these products have been around for a very short period of time—a period when foreign currencies have been weakening against the Dollar. Investors have only seen these products in favorable conditions and may now have unreasonable expectations.
Today, we have the confluence of these three items. The strength of the US Dollar is a classic case of recency bias. Currency-hedged funds are experiencing the bandwagon effect as investors pile in. These funds are new products, and most investors have never seen them lag their peers by 25% when currency moves go the other way.
As with most investments, currency-hedged funds are great tools. However, currencies move in both directions—it is a two-way street. I own some currency-hedged funds today, and maybe you do too. However, I believe they are appropriate only when the Dollar is gaining strength, and I do not believe the current trend will last forever. If you own a currency-hedged fund, I strongly urge you to have an exit plan—don’t let the bandwagon take you over the cliff when the next major currency trend commences.
All the best…
Jerry
