To hedge or not to hedge, that is the question
- The decision whether to hedge the international currency exposures of a portfolio can have a meaningful impact on both portfolio risk and returns.
- Deciding how much currency exposure to hedge is dependent on the investor, the portfolio asset allocation and the economic environment.
- The size of the investor’s portfolio to be hedged typically determines how the hedging strategy is implemented and the solutions available.
Why currency matters
To start with the basics, every international investment can be broken down into two parts. The first is probably the most obvious: the asset itself. Whether equity or debt, it is most likely that an investment is bought for the exposure it gives to a particular company or country. However, when investing internationally, it is important to understand the second part of an investment, which is the currency denomination.
When buying shares in Volkswagen, for example, an investor is exposed to the success or failure of the company in its returns. However, a US dollar based investor is also exposed to the appreciation or depreciation of the euro. If Volkswagen does well and its stock appreciates in value by 10% over a year but the euro relative to US dollar depreciates by 10%, then an investor’s return is zero if the currency exposure was not hedged. Similarly, the converse is also true, where a company’s stock could decrease by 10%, and if an investor has not hedged their currency exposure and the euro appreciates by 10%, the return would again be zero.
Exhibit 1 demonstrates how currency movements have impacted the calendar-year returns of an international equity portfolio for a US dollar based investor over the last 35 years.
Exhibit 1: Currency impact on international equity returns
Deciding on the amount of currency risk to take (the hedge ratio)
The decision whether to hedge currency exposure is dependent on three main variables: the investor’s risk appetite; the portfolio composition; and the economic environment. For investors, as with any investment decision, it is important that they understand their ability and their willingness to take risk. An investor that is unable or unwilling to take risk would typically wish to reduce the uncertainty of their portfolio. Managing currency risk can be a simple way of doing this.
For a US dollar based investor with a 60/40 international equity and bond portfolio, currency volatility is around 8% per annum when measured since 2000. This currency volatility can have a significant effect on the returns of the international portfolio. By hedging the appropriate amount of the foreign currency exposure the investor could potentially reduce the overall risk of the international portfolio. Determining the most appropriate hedge ratio will depend to what extent the foreign asset behaves like it is denominated in a foreign currency and therefore to what extent the FX hedging returns are negatively correlated with the unhedged foreign asset returns.
A portfolio’s asset allocation also has a substantial impact on how much currency risk should be hedged. Less volatile assets, such as bonds, typically derive a greater proportion of their overall risk from currency than higher risk assets, such as equities. As a result, it may be more appropriate over the long term to use higher hedge ratios for portfolios that are largely exposed to bonds than for portfolios that are largely exposed to equities. The counter cyclical nature of the US dollar also typically leads to higher hedge ratios. However, the optimal hedge ratio is also dependent on the underlying currency exposure of the portfolio and should be reviewed on a case-by-case basis.
The current currency market environment
There are many different ways in which currencies can be analysed. Three of the most common include interest rate differentials (carry), valuations and economic fundamentals. Currency is a relative game and, as such, when making currency decisions, US dollar based investors are deciding on the performance of the US dollar vs. a foreign currency.
Carry is the difference between borrowing in one currency and lending in another. For a US dollar based investor, hedging currency exposure involves buying US dollars and selling the foreign currency in the portfolio. For a euro-based investment, the carry equates to +0.8% per annum and for a sterling-based investment the carry equates to +0.2% per annum return, if fully hedged based on current market prices as of 31 December 2020 (Exhibit 2). Interest rate differentials have closed over the past months as central banks have cut interest rates, resulting in is less carry to be gained or lost when hedging. Theoretically, therefore, currencies should become more stable if an investor believes that interest rate parity holds.
Exhibit 2: Carry on hedging EUR and GBP denominated assets for a US based investor
A significant proportion of investors discount currency returns when investing as they believe “currencies revert to a fair value over the long term”. While there is evidence to support this claim, the move towards fair value can take multiple years to occur and thus currency can have a significant impact on returns over shorter investment time horizons. The decision for investors is whether unnecessary currency risk should be taken at all over the long term if currencies do indeed revert around a fair value, or whether there is an opportunity to take advantage of short-term valuation discrepancies to earn additional returns. Currency risk is unrewarded risk. As such, if an international investor believes that currencies mean revert to fair value over the long term and appropriately hedges to reduce the currency risk, the investor can reallocate this ‘saved’ risk elsewhere to push the overall portfolio further out the efficient frontier.
Exhibit 3: EURUSD spot price vs fair value as measured by RPPP
There are many different economic fundamentals that can have a significant impact on a currency’s valuation, including a country’s balance of payments situation and its fiscal position, as well as geopolitical factors. The US runs large current account and fiscal deficits, which typically lead to a weaker currency, as they require funding from international investors. This situation, combined with potential political uncertainty, could lead to US dollar weakness in the short term.
How to manage currency risk in a portfolio
There are three main vehicles for hedging currency risk and these are largely dependent on the size of the investor. For smaller investments, currency-hedged share classes are often made available by asset managers for their most popular products. These hedged share classes offer a disciplined way of reducing currency risk in a simple manner. Larger investors, on the other hand, will have the opportunity to utilise hedging within segregated portfolios of different asset classes. Hedging in this format allows for greater flexibility in managing currency risk, which can be tailored to meet the underlying investor’s objectives. Finally, investors may be able to access currency overlay strategies. These strategies view currency separately to the underlying assets and offer the greatest flexibility for institutional investors.
Once an investment vehicle has been decided upon, the final decision is the approach to managing currency risk. Should an investor adhere to hedging a static percentage of their portfolio’s currency risk or is the investor willing to dynamically adjust the hedge ratio depending on the market environment? Each approach has potential benefits and is dependent on the risk and return objectives of the investor.
Since our first segregated currency overlay mandate funded in 1989, J.P. Morgan Currency Group has grown to manage a total of USD 420 billion (as of 30 September 2020) in bespoke currency strategies. Our clients include governments, pension funds, insurance clients and fund providers. Based in London, the team consists of 18 people dedicated exclusively to currency management with an average of over 15 years of investment experience.
We offer a range of hedging solutions for managing currency risk as well as a tailored optimal hedge ratio analysis:
- Passive currency hedging serves to reduce the currency volatility from underlying international assets. It is a simple, low cost solution designed to achieve the correct balance between minimising tracking error, effectively controlling transaction costs and efficiently managing cash flows.
- Dynamic “intelligent” currency hedging aims to reduce currency volatility from the underlying international assets and add longterm value over the strategic benchmark. A proprietary valuation framework is used to assess whether a currency looks cheap or expensive relative to the base currency and the hedging strategy is adjusted accordingly.
- Active “alpha” currency overlay offers passive currency hedging, if required, combined with an active investment process to deliver excess returns relative to the currency benchmark. Our approach is to build a global currency portfolio combining the output of fundamental models and incorporating the qualitative views of our strategy team.