The impact of currency hedging for global portfolios has been debated extensively. Interest on this topic would appear to loosely coincide with extended periods of strength in a given currency that can tempt investors to evaluate hedging with hindsight. The data studied show performance enhancement through hedging is not consistent. From the viewpoint of developed markets currencies—equity, fixed income, and simple multi-asset combinations— performance leadership from being hedged or unhedged alternates and can persist for long periods. In this paper we take an approach from a risk viewpoint (i.e., can hedging lead to lower volatility or be some kind of risk control?) as this is central for outcome-oriented asset allocators.
The Debate on FX Hedging in Global Portfolios Is Not New
A study from the 1990s2 summarizes theoretical and empirical papers up to that point. The solutions reviewed spanned those advocating hedging all FX exposures—due to the belief of zero expected returns from currencies—to those advocating no hedging—due to mean reversion in the medium-to-long term— and lastly those that proposed something in between—a range of values for a “universal” hedge ratio. Later on, in the mid-2000s the aptly titled Hedging Currencies with Hindsight and Regret took a behavioral approach to describe the difficulty and behavioral biases many investors face when incorporating currency hedges into their asset allocation. In addition to academics, many industry practitioners have tackled the FX hedging dilemma.4 Our study explores this question drawing from similar methodologies and benefits from the data availability of hedged indices for both equity and fixed income, data, which to our knowledge, was not extensively available in the past. As such, we take a data-driven approach to glean insights from the historical risk-return profiles in equities, fixed income, and simple 50/50 multi-asset portfolios.
Why Hedge FX?
Foreign currencies (FX) are a means of exchange for global transactions. However, FX plays a key function in global investing both as an asset class in its own right and as a component of financial asset returns. Very simply, global investors need to convert foreign currency-denominated investments into their portfolio’s base currency. This activity can lead to gains or losses that may be totally unrelated to a security’s fundamentals. A hedged position can remove the losses when the currency moves adversely, but also mute gains if the currency moves favorably. While we recognize currency effects can be considered within fundamental security analyses—by adjusting valuation model parameters—it is also an important concern at the portfolio construction level or for institutional asset owners. Hedging has been a widely discussed subject for many years and interest in the topic would appear to fluctuate along with major currencies’ moves. We are approaching this paper by focusing on currency hedging as a potential tool for portfolio risk control. While we believe that value can be added from active currency management, we need to separate the return generation goals from the risk control objectives—as these two are competing goals. In other words, we will look at asset returns where hedging is “passive” and there is no tactical timing element to put in the hedges or to take active views on certain currency pairs.
Data and Methodology
The analysis and results center on global developed markets equity and fixed income indices. Results are calculated from the point of view of the following developed markets currencies: US dollar (USD), Australian dollar (AUD), British pound (GBP), Canadian dollar (CAD), euro (EUR), Japanese yen (JPY), and Swiss franc (CHF). Importantly, EUR returns for both equity and fixed income are only available since its inception in 1999. The main reasons for excluding emerging markets is insufficient availability of data. Perhaps more importantly, hedging emerging markets currencies in practice can be more expensive and results using cost-free index data may underestimate actual results by a greater margin than in the developed world. The time period analyzed spans almost three decades of monthly returns and is restricted by our availability of hedged index data. In equities, we cover the period from December 1987 to December 2017 based on the MSCI World Index. We utilized price returns only, given that total return hedged indices have a shorter history. In cases where hedged indices were not available, we used the “local” return calculated by MSCI. This “local” return represents the theoretical performance by removing all currency effects. This differs from the hedged returns calculation where a specific hedge impact (calculated by MSCI as a hypothetical 1-month forward contract) is used to adjust the returns in a given currency. In terms of performance, hedged and “local” returns will be different, but in terms of risk their profiles are virtually the same. With this in mind, using local for risk-based analysis is appropriate wherever hedged indices are missing
Comments