Revisiting Currency-Hedged Equity Strategies in a High-Yield Environment

In a high-yield environment marked by shifting macroeconomic dynamics, currency-hedged equity strategies have reemerged as critical tools for income generation and risk mitigation. As central banks globally pivot toward rate-cutting cycles in 2025, investors are recalibrating their portfolios to balance yield-seeking objectives with the volatility of cross-border currency exposures. Recent data and academic insights underscore the nuanced role of hedging in international equity allocations, particularly as the U.S. dollar's traditional behavior as a safe-haven asset has diverged from historical norms.

The Case for Hedging in a Weak-Dollar Regime

The unexpected weakness of the U.S. dollar in 2025 has amplified the value of currency-hedged strategies. For instance, a Euro-based investor with an unhedged U.S. equity allocation faced steep losses, with the Russell 1000 and Russell 2000 indices returning -13.5% and -19.4% in Euro terms through April 2025. However, hedging dollar exposure reduced these losses to -5.1% and -11.6% in USD terms, respectivelyCurrency risks in global equity portfolios | LSEG^[1]. This outcome highlights how currency volatility can overshadow equity performance, particularly during periods of market stress when the dollar's inverse relationship with equities breaks downCurrency risks in global equity portfolios | LSEG^[1].

The dollar's underperformance defied expectations tied to anticipated tariff policies and traditional safe-haven dynamics, challenging investors to rethink hedging as a core risk-management toolCurrency risks in global equity portfolios | LSEG^[1]. According to a report by LSEG, such shifts in currency correlations underscore the need for dynamic hedging strategies that adapt to evolving macroeconomic conditionsCurrency risks in global equity portfolios | LSEG^[1].

Performance Metrics: Hedged vs. Unhedged Portfolios

Over the past decade, currency-hedged strategies have consistently outperformed their unhedged counterparts in high-yield environments. The MSCI EAFE Currency Hedged Index delivered 137% total returns (9.0% annualized) from June 30, 2015, to June 30, 2025, compared to 88% (6.5% annualized) for the unhedged versionBlog | Currency Hedging: how has it worked and how might it work… | DWS^[2]. This outperformance is attributed to two factors: the U.S. dollar's relative strength during much of this period and the income generated from hedging costs reinvested into USD-denominated assetsBlog | Currency Hedging: how has it worked and how might it work… | DWS^[2].

Similarly, the iShares Currency Hedged MSCI EAFE ETF (HEFA) generated 8.9% annualized returns over the trailing 10 years ending in 2024, outpacing the iShares MSCI EAFE ETF (EFA) by nearly 400 basis pointsWhy Holding Assets Outside the US Dollar Has Paid Off 2025 | Morningstar^[3]. However, the reverse is true during periods of dollar weakness. For example, the Morningstar Global Markets ex-US Index gained 14% year-to-date through May 29, 2025, while the U.S. benchmark remained flatWhy Holding Assets Outside the US Dollar Has Paid Off 2025 | Morningstar^[3]. This duality illustrates the importance of aligning hedging decisions with macroeconomic forecasts and currency outlooks.

Academic Insights: Investor Behavior and Model Uncertainty

Recent academic research in 2025 has deepened the understanding of currency hedging's role in investor decision-making. A study in the Journal of Banking & Finance found that ambiguity aversion—investors' discomfort with uncertain models—significantly increases demand for hedging in international portfoliosGlobal currency hedging with ambiguity | Journal of Banking & Finance^[4]. This is particularly relevant in high-yield environments, where economic uncertainty amplifies the perceived risks of currency exposureGlobal currency hedging with ambiguity | Journal of Banking & Finance^[4].

Additionally, the Review of Financial Studies introduced the “hedging channel” model, which links a country's external imbalances to exchange rate behavior. This framework explains how investors adjust hedging strategies in response to macroeconomic shifts, influencing global capital flows and equity market dynamicsGlobal currency hedging with ambiguity | Journal of Banking & Finance^[4]. Together, these insights highlight the interplay between behavioral finance and structural economic factors in shaping hedging decisions.

Hedging Trade-Offs: Volatility, Costs, and Strategic Balance

While hedged strategies often reduce portfolio volatility, they are not universally risk-reducing. Research indicates that hedging can increase total portfolio volatility when a negative correlation exists between asset returns and currency movementsCurrency risks in global equity portfolios | LSEG^[1]. For example, unhedged exposure may offer natural diversification benefits during periods of dollar depreciation, as seen in the 2008 financial crisis when a weaker Australian dollar cushioned losses for global equity portfoliosWhy Holding Assets Outside the US Dollar Has Paid Off 2025 | Morningstar^[3].

Investors must also weigh the costs of hedging, including higher expense ratios and tax inefficiencies from forward contractsWhy Holding Assets Outside the US Dollar Has Paid Off 2025 | Morningstar^[3]. A balanced approach, such as a 50% hedge ratio, is often recommended to mitigate volatility without sacrificing potential gains from favorable currency swingsTo hedge, or not to hedge, that is the question | CCL Group^[5]. For income-focused portfolios, this balance is critical, as hedging costs can erode yield premiums if not offset by strong equity performanceTo hedge, or not to hedge, that is the question | CCL Group^[5].

Strategic Recommendations for 2025

Given the current macroeconomic landscape, investors should consider the following:
1. Dynamic Hedging: Reassess hedging ratios quarterly to adapt to shifting dollar dynamics and interest rate differentials.
2. Sector-Specific Hedging: Prioritize hedging in sectors with high currency sensitivity, such as multinational corporations or emerging-market equities.
3. Cost Efficiency: Opt for low-cost hedging instruments, such as currency ETFs or exchange-traded notes, to minimize drag on returns.
4. Scenario Analysis: Model outcomes under both dollar-strength and dollar-weakness scenarios to stress-test portfolio resilience.

Conclusion

Currency-hedged equity strategies remain a vital component of income-focused international portfolios in 2025. While the U.S. dollar's recent weakness has amplified the benefits of hedging, the interplay between macroeconomic shifts, investor behavior, and currency volatility demands a nuanced approach. By leveraging performance data, academic insights, and strategic hedging frameworks, investors can navigate high-yield environments with enhanced risk-adjusted returns.