On his Investment Ideas blog post Currency Hedging Necessary? of May 7th, Larry MacDonald cites the Chou funds annual report 2007 letter and several academic studies ((The Performance of Currency-Hedged Foreign Equities by Lee Thomas and (Hedging Currencies with Hindsight and Regret by Meir Statman and Kenneth Fisher) referred to therein saying that removing the risk arising from currency exchange swings is unnecessary. The long term (15+ year) returns were about the same for portfolios with and without hedging, as was the traditional measure of risk, standard deviation.
Is that the end of the story, the definitive answer for the investor who wants to hold a diversified portfolio that includes substantial international holdings? Apparently not.
Gary Klopfenstein and Fred Stambaugh of BancOne Currency Advisors show in Currency Risk Management in International Portfolios that the traditional measure of risk - standard deviation - used in the above studies does not adequately reflect currency movements. Big swings / extreme events in currency occur far more often that standard deviation based on a normal distribution says they should and this causes big, hidden downside risks. Instead they apply Extreme Value Theory and show that portfolio returns can be significantly improved while risk is reduced. This is accomplished not through traditional methods of currency futures or options (assumed in the hedging done in the traditional studies) but through something termed active currency management, which Banc One conveniently offers as the Banc One Currency Advisors Currency Overlay Program (a fancy label is required to market this to the target institutional investors).
Unfortunately, how that works is not described, nor is the study named that purports to show a 0.5% per quarter improvement in returns while eliminating "calamity risk". So it's hard to tell if this is a real prophylactic for a foreign investor or just another magic elixir. And then of course, can the individual investor do something similar or are there reasonably priced products that do so?