We examine a hypothetical strategy for switching between unhedged and currency-hedged international equity exposure based on the US Dollar Index's P&F chart.
As we’ve discussed at various points over the last couple of months, the US dollar has experienced significant weakness this year as the US Dollar Index (DX/Y) declined more than 10% from its January peak to its April low. The falling dollar has been a significant tailwind for international equities, which have handily outperformed US stocks – year-to-date (through 5/14) the iShares MSCI EAFE ETF (EFA) is up 13.87%, while the S&P 500 (SPX) is essentially flat.
While not the only consideration for international exposure, currency movements can have a major impact on returns. While EFA is up almost 14% this year, the iShares Currency Hedged MSCI EAFE ETF (HEFA), which hasn’t benefited from the weakness in the dollar, has gained only about 7%. Of course, this isn’t a one-way street – during periods when the dollar is rising, we would expect the currency hedged ETF to outperform.
As the disparity between the returns of EFA and HEFA this year illustrate, international equity returns could potentially be significantly enhanced by alternating between hedged and unhedged exposure to take advantage of currency movements. One possible strategy for alternating between hedged and unhedged exposure is using the point & figure signal of the US Dollar Index, which has trended well in recent years. Initial buy and sell signals have often been followed by multiple consecutive signals with substantial moves between signal changes. Since giving an initial sell signal with a double bottom break at $107.50 in January, DX/Y has given two additional sell signals and fallen to a low of $98.50. We saw similar orderly trends to the upside and downside between 2021 and 2023.
To test the effectiveness of DX/Y’s P&F signal as an indicator we looked at three scenarios – buying and holding the iShares MSCI EAFE ETF (EFA), buying and holding the iShares Currency Hedged MSCI EAFE ETF (HEFA) and switching between the two based on DX/Y’s P&F signal – holding EFA when DX/Y is on a sell signal and holding HEFA when the dollar is on a buy signal. Our study uses price return data and goes from February 28, 2002, the first date for which we have available data for HEFA, through 5/13/25.
The returns for our holding period show a significant performance advantage for the switching strategy. Over that period, the unhedged ETF, EFA, generated a cumulative return of just under 132%. Its currency-hedged counterpart, HEFA, performed better, producing a cumulative return of 191.4%. However, the switching strategy significantly outperformed both funds, generating a cumulative return of around 370%.
The table below shows every signal change for the US dollar index since 2/28/03 and the returns for each period. Over that 20+ year period, DX/Y has seen 60 signal changes, which means our hypothetical strategy would have had 60 trades, or roughly 2.6 trades per year. While not an overwhelming number of trades, as the entire portfolio (or sleeve) is being traded each time, it does represent annual turnover of around 260%. You can also see that while there have been long intervals between trades – like March 2021 to October 2022, there have also been instances where the switching strategy has traded in-and-out of a position in less than 10 days. It is also apparent that not every trade has been a winner, there have been several occasions when the switching strategy ended up on the wrong side of the currency hedge, however, the magnitude of the wins has more than made up for the losing trades. Overall, using DX/Y’s P&F signal as a currency hedging trigger has worked out quite well over the previous 20+ years, but the signals haven’t always been quite as reliable as they have been over the last few years.
A few notes on these results. The hypothetical switching strategy outlined above doesn’t account for any tax or transaction costs, which would certainly be higher than in the two buy-and-hold scenarios. It should also be noted that this study was conducted using return data for developed international equities. It shouldn’t be assumed that the results would be the same for any other international equity exposure. The basket of currencies that underly the US Dollar Index are all developed market currencies, so it’s reasonable to expect that the DX/Y signals used in our study are a more useful indicator for developed market currencies than they are for emerging markets, for example.
