I am building a global tactical equity allocation model. The model will help determine an optimal allocation amongst a number of major developed and emerging stock markets (represented for my purposes by the MSCI country indices). The model will use inputs such as macroeconomic indicators, local currency yield curves and differentials, valuation (e.g. P/E), momentum, etc.
Should the returns series input into the model be currency hedged or unhedged? In practice, we will have the option of making separate currency bets. Is the fundamental series which should be compared across countries the hedged or unhedged series? To clarify, the goal in making this decision is to maximize our predictive power.
For example, if I were building an options relative value model, I would certainly compare only delta-hedged returns, even though my actual hedging may differ I practice. in this case, however, adding currency hedging may actually be adding noise rather than reducing it.