Investing abroad creates currency risks that are often coincidental rather than the result of deliberate decisions. Leaving currency exposures unmanaged has significantly reduced U.S. investors’ returns on international investments over the past two years. In this blog, we explore how currency exposures can be managed to reduce risk or improve return. When US investors invest in international assets, they are inevitably exposed to exchange rate fluctuations. For example, a US investor who buys an international non-developed market stock index implicitly holds a long position in a basket of currencies composed of approximately 27% euro, 19% Japanese yen, 14% pound sterling, 12% Canadian dollar, and other currencies.1 This currency exposure can have a significant impact on the returns achieved for the US investor. Between the start of 2017 and the end of April 2022, when the US dollar was strong, the MSCI ex-US currency hedged index outperformed the unhedged version by 12.5%.
Leaving foreign currency exposures unhedged could be an implicit bet that US dollar appreciation is over. However, for many investors, foreign currency exposure is not an investment decision from which they expect returns, but a simple by-product of the equity position. In this case, the involuntary risk could be reduced or transformed into rewarded risk.
Currency hedging for risk management
Currency hedging using forward foreign exchange contracts is a good way to reduce unpaid currency risk. By selling forward an appropriate amount of foreign currency, hedging creates positions that move in the opposite direction to the currency exposures of the underlying portfolio. In a static currency hedging program, a constant percentage of the currency risk is hedged, for example 50% or 100%.
In our view, static currency hedging (on average) reduces risk without giving up expected return, over a long enough period. For this reason, some scholars have referred to currency hedging as a “free lunch.”2 This effect is very pronounced for international bonds but also visible for international equities. Between 1997 and today, full currency hedging would have reduced the volatility of non-US global bonds by about 1/2 and that of non-US developed market equities by about 17% relative to the investment not covered.3
Another way to quantify the risk reduction benefit of currency hedging is to look at drawdowns. Again, the numbers for the global ex-US bond portfolio look compelling. Full currency hedging would have reduced the maximum drawdown by $15 million on a $100 million portfolio compared to no currency hedging. For the Developed Markets Non-US Equity portfolio, the decrease in maximum drawdown is approximately $7 million on a $100 million portfolio. Although these historical results are specific to the sampling period studied, we believe that the conclusion on risk reduction will hold in the future. Indeed, the US dollar is a so-called safe haven currency that rises when risky assets such as stocks fall. Currency hedging reduces risk for the US investor because it increases exposure to a safe-haven asset.
Importantly, because the Fed is raising interest rates faster than other major central banks, U.S. investors are getting a positive return by hedging many other developed currencies given the relative level of interest rates (see Figure 1 ).
Is this the right time?
The timing of initiating a hedge against the US dollar may seem somewhat unfavorable given the recent strength of the US dollar. Since the second half of 2020, the US dollar (as measured by the DXY index) has risen from below 90 to above 103 (see Figure 2). The reasons for the rise of the dollar are well known: a growing interest rate differential with the euro and the Japanese yen, as well as the energy independence of the United States in the face of rising oil prices. These reasons may already be taken into account.
Figure 2: DXY US Dollar Index. Source: Bloomberg, as of April 30, 2022.
Whether or not the dollar bull market continues, investors can reduce timing risk by phasing in their currency hedging program, either through a calendar-based approach and/or valuation triggers that increase the currency hedging ratio when the US dollar falls to more attractive levels. . From a strategic point of view, hedging against their home currency could be very desirable for US investors: they reduce the risk that currency fluctuations significantly affect the returns of their international assets. Additionally, the US dollar often appreciates when risky assets like stocks fall. Hedging their home currency (selling foreign currencies and buying dollars) allows US investors to take advantage of the safe-haven nature of the greenback and improve their portfolio diversification.
Dynamic hedging and absolute return currency
find the optimal coverage ratio and the right time to initiate this static coverage is difficult. A different approach is to allow the currency hedging ratio to always be flexible over time, with the aim of generating excess returns over passive hedging. Hedging ratios may be adjusted for currency valuations, interest rates and other factors that determine currency returns. This dynamic currency hedging approach can turn the ancillary currency risk of international assets into a source of return. Investors could improve the risk-return outcomes of their portfolios, compared to implementing a static hedging policy or not hedging.
Alternatively, some investors also employ absolute return currency strategies where long-short currency positions are independent of currency exposures in their underlying portfolios. We believe that commonly used factors such as carry, value and trend can drive returns in the forex markets. We find that Japanese investors, who are used to earning very low returns from their fixed income investments, have taken an interest in absolute return currencies in recent years. As U.S. yields rose and fixed income yields suffered, U.S. investors may also turn their attention to currencies.
When investors start thinking about post-pandemic asset allocations, consideration should be given to managing currency exposures. While the US dollar has rallied strongly since the end of 2020, failure to hedge currency exposure in international equity and bond investments has been detrimental to US investors during this period. We believe investors should evaluate their currency management options, whether to phase in a static hedging program, dynamic currency hedging or an absolute return currency. The only course of action that we don’t think is appropriate is to ignore currency exposure.
¹ These are the currency weights in the MSCI ex USA index. Source: MSCI, as of May 5, 2022.
² Perold and Schulman (1998): “The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards”, Journal of Financial Analysts
³ Source: Bloomberg, Refinitiv, Russell Investments, as of April 29, 2022.
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