Should I use currency hedged or unhedged returns for a global equity allocation model?

Question

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.

Question:

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.

Answer 1

Check out:

"Universal hedging: Optimizing currency risk and reward in international equity portfolios," Fischer Black - Financial Analysts Journal, 1989.

as well as many of the subsequent research that references this article (via Google Scholar, for instance). Good luck.

Answer 2

Since currencies are explicitly part of your asset set, it does not matter in principle which choice you make (currency hedged or unhedged) for the other securities.

In order for you model weights to have the most intuitive meaning, you should choose unhedged if you think you will generally be neglecting to hedge the risk, and hedged otherwise.