Wednesday, October 27, 2010

Inherent Value of Businesses

A recent study of currency-hedged foreign equity funds by Raymond KerzĂ©rho 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.

Canadian Capitalist gave a good overview 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.


  1. @CC: I never studied the problem carefully myself. I'm just observing that the insight makes sense now that someone else has uncovered it.

    The first time I became aware of currency-hedged funds, I was skeptical. How could such a thing be constructed without any cost?

    1. The comment above is a reply to Canadian Capitalist's comment:

      Thanks for the mention Michael. I found Mr. Kerzerho's report to be brilliant. I personally never made the connection that negative correlation between currency and stocks is the reason for currency hedged funds showing such large tracking errors.

  2. Sounds like a good explanation to me!

    Could also imply that as companies in the S&P500 become more global, that this negative correlation will get stronger (i.e., that their intrinsic value becomes measured less in dollars and more in a combination of global currencies).

  3. @Potato: That's true. However, even if we could figure out the right mix of international currencies, inflation (or deflation) may affect currencies differently from how it affects the value of businesses. So, the negative correlation between stocks and a basket of currencies may still persist. I'm starting to get further from the edge of my knowledge on this one, though.

  4. We sometimes see this in oil price changes too. If the Canadian dollar appreciates against the US dollar, we sometimes hear about how Americans are subjected to sky-rocketing gasoline prices while we enjoy relatively stable prices.

    That's not the entire story though, as our taxes at the pump are higher, so price changes in the underlying commodity have a muted effect on the overall price per litre.

    I'm sure many people would point to the rise of gold as an indication of a collapsing US currency, but I suspect there is far more at play there, too.

  5. @Gene: This makes sense for just about anything, I guess. If the dollar drops, then prices (measured in dollars) tend to go up. I'm not sure what the rising price of gold means. To abuse a great saying, I'm not much good at predictions, especially about the future.