A recent study of currency-hedged foreign equity funds by Raymond Kerzérho provides some explanations for why these funds tend to perform worse than we expect. This reduced performance is called “tracking error”. I believe this is related to the fact that businesses have inherent value independent of currencies.
Both Larry MacDonald and Canadian Capitalist have given good overviews of this report, but I want to focus in on just one source of tracking error.
One major reason why currency-hedged U.S. stock funds perform below expectations is that the value of the U.S. dollar and the value of U.S. stocks tend to move in opposite directions. For technical reasons with the way these currency-hedged funds operate, this negative correlation gives rise to tracking error.
The idea that stocks and currencies tend to move in opposite directions makes perfect sense if you start from the point of view that businesses have inherent value that is at least partially independent of currency. When the U.S. dollar moves up or down, is there any reason to believe that the inherent value of Walmart has changed?
If Walmart maintains its inherent value, but the U.S. dollar goes down, it makes perfect sense that the value of Walmart measured in U.S. dollars would go up. Of course, stock values are not completely independent of currency fluctuations, but it makes sense that U.S. stock funds will tend to continue to move in the opposite direction of the U.S. dollar.