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FOREIGN CURRENCY HEDGING ON GLOBAL EQUITY PORTFOLIOS

THIS DOCUMENT IS INTENDED FOR INSTITUTIONAL INVESTORS ONLY. IT SHOULD NOT BE DISTRIBUTED TO, OR USED BY, INDIVIDUAL INVESTORS. CONTENTS

Executive summary 1

1 Considering static passive hedge ratios 3

1.1 Variability of returns over different time horizons 5

1.2 Static hedging ‒ further considerations 6

2 Our dynamic hedging process 7

2.1 Dynamic hedging model structure 7

2.2 Estimating risk benefit 8

2.3 Expected return impact of hedging 9

2.4 Combining FX factors 11

3 Key performance outcomes 12

3.1 Dynamic hedge downside protection 14

4 Conclusion 16 INTRODUCTION

As investors increasingly allocate to globally diversified portfolios, currency movements have a greater bearing on the variability of returns. Consequently, managing currency risk becomes a critical strategic decision for investors.

In this paper, we consider the different options available to investors seeking to manage currency exposures. We also share our research findings on how best to manage such risks from a portfolio perspective. We argue that the most effective hedging approach should be dynamic in nature, and responsive to a number of key currency risk factors. These include interest-rate differentials, valuation and FX/equity co-movement. Finally, we demonstrate the benefits of this approach versus competing hedging strategies.

EXECUTIVE SUMMARY

A recurring theme in international investment is whether or not From a total portfolio perspective, placing total portfolio risk to hedge foreign currency exposure, and if hedging, whether the and return at the core of our modelling, we have developed process should be static, dynamic, one-size-fits all, or currency specific. a process where risk and return characteristics are empirically estimated, rather than assumed. We identify a number of key In this paper, we address each of these issues. Overall, we find that factors that have historically improved the risk/return benefit of portfolios benefit from foreign exchange (FX) hedging. While a 100% currency hedging and the associated impact on portfolio return. static hedge across all FX exposures is a simple and popular approach We also propose a systematic dynamic hedging framework that delivers reduced volatility, it assumes a set of relationships between which incorporates these factors in determining optimal forward- currency and equity risk and return that do not generally hold true. looking currency hedge ratios on a per-currency basis. Finally, Consequently, we find it to be sub-optimal. we demonstrate the enhancement this approach offers versus conventional passive currency-hedging strategies.

In summary: Hedging can improve outcomes – specifically reducing the variability of short-to-medium term returns and negative tail outcomes across all base currencies. Timing is important, and the benefits of hedging change through time. Over longer time frames, the efficacy of passive hedging can depend on a number of key factors, including currency trends, valuations and global interest-rate differentials. We demonstrate that investors can improve the level and stability of portfolio risk-adjusted returns by incorporating these factors into a dynamic hedging framework versus static, passive hedging strategies.

Foreign Currency Hedging on Global Equity Portfolios 1 CURRENCY RISK: IMPACT ON INVESTOR RETURNS With any globally diversified equity allocation, currency forms a significant component of return and risk for investors. Looking at the annual differential between the MSCI World Unhedged index versus local returns, we see sizable performance swings across the last 47 years, with a meaningful currency impact over recent years. Exhibit 1 illustrates the magnitude and continued relevance of FX risk for investors, and presents a strong case for considering how best to manage this important component of portfolio risk.

The below exhibit illustrates the FX risk/reward clients are exposed to from an international equity portfolio, and why they should care to read on. Exhibit 1: Currency impact on total returns 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 -0.25 -0.20 -0.15 -0.10 -0.50 0.00 0.50 0.10 0.15 0.20 0.25 Source: Factset. Past performance is not a reliable guide to future performance.

A SUMMARY OF INVESTORS' OPTIONS To begin, let us outline the range of FX hedging options available to investors seeking to manage their currency exposures.

FX Strategy Overview Passive Passive strategies aim to strip out any FX exposure from a body of assets by implementing a portfolio of hedging FX forwards. These passive hedges can range from a full 100% hedge of FX exposure, to fractional hedge ratios such as 50% or 33%, as deemed appropriate for the fund. The key consideration here is the degree of aversion to FX risk. The hedge may be applied equally across all foreign currency denominations, or by applying a variable hedge fraction to different currencies. Active Active strategies seek to add alpha by forecasting returns and taking long/short positions dynamically across a range of currency pairs. Unlike passive strategies, they will, at times, take on additional FX risk (versus a broader portfolio), and do not simply reduce FX exposure. Return forecasts are typically driven by factors such as interest-rate differentials (carry), momentum and valuation. Dynamic A dynamic hedge aims to maximise the expected risk-and-return impact of hedging by setting an optimal currency specific hedge ratio at each point in time. This is a hybrid approach, in that some of the classic FX factors typically used in an active currency programme are considered when determining the appropriate or inappropriate times to hedge.

2 Foreign Currency Hedging on Global Equity Portfolios PART 1: CONSIDERING STATIC PASSIVE HEDGE RATIOS

There is considerable debate on the optimal static hedge ratio for a While the Euro (DEM)i historic experience is of particular interest book of assets with FX exposure. A range of well-regarded authors to us, it represents the outcome from the perspective of just have come up with different answers, ranging from 0%¹, to near one base currency. To present a more complete picture of the 100%². Theoretical arguments have been made from a ICAPM performance of passive hedging strategies, our research examines (“The International Capital Asset Pricing Model”) perspective the historic performance of a range of investor base currencies. (Fisher Black³,⁴) to put forward a universal hedge ratio, often The tables overleaf set out the historic performance (1977–2016) cited at around 77%. In another study, 30%⁵ has been proposed of different hedge ratios as determined by a range of key risk and as optimal for US pension plans where the impact of transaction return metricsii. These tables show a euro base and an average costs is fully included. across EURi, USD, JPY, GBP, AUD, CAD, and CHF. The results To gauge the benefits of currency hedging at various degrees, we (allowing for transaction costs on hedging positions) evidenced analysed the risk and return impact of a range of passive hedging by the average are generally very consistent across each of the strategies. Here, we considered an investor holding a global sample bases. index portfolio tracking the MSCI World versus an unhedged benchmark over multiple time periods.

Key insights:

Static currency hedging meaningfully improves risk-adjusted return metrics across all bases. For the euro base, we see both positive return and risk impacts, while the average across all bases shows an improvement in volatility with negligible change in returns.

Total drawdown and beta statistics reduce with the increase in hedge ratio, with the greatest reduction at a 75–100% hedge.

Maximum drawdown/Sharpe ratios improve with the increase in hedging ratio. However, these benefits level off at higher hedging ratios – peaking at around the 75% hedge ratio level.

From an absolute return/risk perspective, we can assert that a relatively high hedging ratio of between 75%–100% appears optimal.

Foreign Currency Hedging on Global Equity Portfolios 3 HISTORICAL SIMULATION Exhibit 2: Performance summary for fractional static hedge ratios – euro and average of base currencies (USD, GBP, JPY, CAD, CHF, AUD) Sharp Ratio Euro base Average of FX bases

0.50 0.47 0.46 0.40 0.45 0.44 0.30 0.43 0.42 0.20 Sharpe Ratio Sharpe Ratio 0.41 0.10 0.40 0.39 0.00 0.38 0% 25% 50% 75% 100% 0% 25% 50% 75% 100% Hedge Hedge Hedge Hedge Hedge Hedge Hedge Hedge Hedge Hedge

MSCI World Euro Base MSCI World Average of FX Base

Performance Summary 1977 ‒ 2016: MSCI World Euro Base 0% Hedge 25% Hedge 50% Hedge 75% Hedge 100% Hedge Annualised Return 9.84% 10.07% 10.27% 10.43% 10.55% Volatility 15.58% 14.81% 14.24% 13.89% 13.78% Total Drawdown 62.00% 52.53% 45.28% 41.13% 38.80% Max Drawdown -54.15% -51.56% ‒ ‒ ‒ Sharpe Ratio (3%) 0.35 0.39 0.42 0.44 0.45 Beta 1.00 0.95 0.89 0.84 0.79 Tracking Error ‒ 1.85% 3.69% 5.54% 7.39%

Performance Summary 1977 ‒ 2016: MSCI World Average FX Bases 0% Hedge 25% Hedge 50% Hedge 75% Hedge 100% Hedge Annualised Return 10.08% 10.15% 10.17% 10.15% 10.01% Volatility 15.23% 14.49% 13.98% 13.73% 13.75% Total Drawdown 53.14% 46.79% 43.14% 41.19% 41.14% Max Drawdown -52.33% -50.71% -49.56% -49.18% -50.45% Sharpe Ratio (3%) 0.41 0.43 0.45 0.46 0.45 Beta 1.00 0.95 0.90 0.84 0.79 Tracking Error ‒ 1.92% 3.84% 5.76% 7.73%

Source: ILIM, based on back-tested data from 1977–2016i.. Past performance is not a reliable guide for future performance.

In further tests, dividing the sample into half one (H1) and half two (H2) demonstrated that these benefits are also persistent. Both volatility and total drawdown metrics see improvement over H1 and H2 sub samples. As there is no significant impact on return, performance of return/risk metrics is also enhanced.

4 Foreign Currency Hedging on Global Equity Portfolios 1.1 VARIABILITY OF RETURNS OVER DIFFERENT TIME HORIZONS

A criticism of passive hedging is that the benefit relates only to annualised daily/monthly volatility, and does not extend to Key insights: the variability of returns over longer horizons. Intuitively, this For all bases, hedging reduces the variability of returns, reflects the fact that over longer investment horizons, the impact with the greatest impact over the short-to-medium term. of currency fluctuations decreases relative to the impact of compounding equity market returns. The only exception is the CAD base, where there is a slight increase in monthly variability. However, for Although we have already addressed this indirectly by looking at longer return intervals, results were consistent with drawdown statistics, we now look explicitly at the variability of other currencies and the average of all bases. annualised return outcomes, with return horizons of 1, 3, 5 and 10 years, alongside the annualised monthly volatilities. Return variability reduction is greatest over the same type of medium-term time horizons in which equity market In exhibit 3 below, we see reduced variability for both the EUR and drawdowns typically occur. average base investor over rolling 1,3,5,10-year samples for hedged vs. unhedged returns with greatest impact over the short-to-medium term. This gives further support to the risk management case for hedging FX exposure on a global equity portfolio.

Exhibit 3: Standard deviation of annualised return outcomes on 1 month, 1, 3, 5, 10-year intervals Please note that the 1-month data represents the annualised standard deviation of monthly returns, whereas the 1-year data represents the standard deviation of annual returns, i.e. all overlapping 12-month returns over the full sample.

EuroCHF basebase USDAverage base of all bases (USD, GBP, JPY, CAD, CHF, AUD)

25.0%25.0% 20.0%25.0% NoNo hedgehedge No hedge 100%100% hedgehedge 100% hedgehedge 20.0%20.0% 20.0% 15.0%

15.0%15.0% 15.0% 10.0%

10.0%10.0% 10.0%

5.0% 5.0%5.0% 5.0%

0.0%0.0% 0.0% 11 month month 11 yearyear 33 year year 55 year year 1010 year year 1 monthmonth 11 yearyear 33 yearyear 55 year year 10 year

Source: ILIM, based on back-tested data from 1977–2016i.. Past performance is not a reliable guide for future performance.

This data supports the fact that FX hedging (from a risk perspective) has the greatest impact/benefit over short-to-medium term horizons, while over the longer term, the relative impact reduces. We note, however, that capital losses on equity portfolios are typically realised over the same short-to-medium-term timeframes, but are no less of a concern for investors. Hedging helps to dampen return variability of equity portfolios over such timeframes.

Foreign Currency Hedging on Global Equity Portfolios 5 1.2 STATIC HEDGING – FURTHER CONSIDERATIONS

On balance, the available evidence supports the adoption of a static passive hedge over a fully unhedged position. Hedging offers a reduction in the variability of returns, particularly over 1–3-year horizons, and a material improvement in the stability of the risk adjusted return ratios.

It is important to note that, in practice, the optimal hedging ratio will be investor specific. It will depend on the book of assets in question, the risk sensitivity/horizon of the investor, and not least on their base currency’s valuation, interest rate, and risk/’safe- haven’ characteristic. Indeed, the key drivers of a passive hedge ratio decision can be summarised as follows. Considerations in determining a static hedge ratio

Key factor Impact on Explanation to consider Hedge Ratio Higher allocation to foreign Currency risk has a higher proportional impact on lower bonds than foreign equities risk assets such as bonds Higher allocation to foreign High Foreign Assets equates to higher proportional assets currency risk (unless in the same currency e.g. Euro) Shorter horizon/higher rsk Currency risk has greatest impact on short time periods ‒ Strategic factors aversion mean reversion reduces longer term impact Higher negative correlation of 'Safe haven' currencies like the yen, and Swiss franc are equities with base currency generally negatively correlated to global equity markets. This increases the risk to un-hedged Swiss and Japanese investors Lower associated carry cost of The carry trade has an impact on the benefits of hedging hedging and effects can compound over time Base currency undervalued Risk of base currency appreciation warrants higher

Dynamic factors Hedge Ratio Higher positive momentum for FX markets exhibit trend with impact on hedging return Base Currency

Therefore, even assuming there is no change to an investor’s strategic positioning, changes in dynamic factors due to market movements will influence the optimality of different hedge ratios through time on a currency-by-currency basis. This presents the implication that optimal FX hedging should also be dynamic.

Summary

On balance, the available evidence supports the adoption of a static passive hedge over a fully unhedged position. Hedging offers a reduction in the variability of returns, particularly over 1–3-year horizons, and a material improvement in the stability of risk-adjusted return ratios.

In determining whether to apply a static hedge and at what ratio, a number of relevant factors should be considered. In recognising the time-variant nature of these factors, we have been motivated to develop a dynamic hedging process, and this is set out in the following section.

6 Foreign Currency Hedging on Global Equity Portfolios PART 2: OUR DYNAMIC HEDGING PROCESS

Recognising the importance of dynamic factors on an investors optimal hedge ratio, ILIM’s Quantitative Strategies Group (QSG) have developed a dynamic currency hedging process which seeks to improve risk-adjusted returns on a global equity portfolio through currency risk management. This process reduces nominal FX exposures to any foreign currency, so that the hedge ratio will be between 0–100% of the exposure in the physical equity portfolio. The hedge ratio is then set on a currency-by-currency basis, allowing a dynamic response to changes in the underlying drivers of risk and return.

An attractive feature of this approach is that it allows us to increase the overall portfolio’s exposure to FX return factor premia such as carry, valuation and momentum, while simultaneously reducing absolute risk. Consequently, a dynamic hedge represents a very appealing risk/return proposition for investors. It offers a potential gain in return with reduced absolute portfolio risk.

2.1 DYNAMIC HEDGING MODEL STRUCTURE

The model we have developed is multi factor in nature and seeks to exploit both return and risk insights as follows:

Risk Return Optimum risk/ benefit impact return

We estimate the volatility of FX We determine the expected Based on expected volatility and equities and their expected return/costs associated with and correlation estimates, correlations. This allows us to applying a hedge based we aim to isolate the hedge estimate forward-looking risk on carry, valuation and ratio that will maximise enhancement for a given hedge. momentum characteristics, the portfolio’s expected and explicit trading costs. Sharpe ratio, allowing for expected hedge return (hedge opportunity cost) and other associated hedging costs.

Foreign Currency Hedging on Global Equity Portfolios 7 2.2 ESTIMATING RISK BENEFIT

In terms of estimating the risk benefits of an FX hedge, we must variability in the level of individual estimates through time. As consider the correlation between foreign currency exposures expected, we see that the Australian dollar tends to positively and equities. For foreign currencies that tend to have positive correlate with equities, while the safe-haven Swiss franc tends to correlations with equity markets (e.g. the Australian dollar), negatively correlate with equities and appreciate during risk-off we would expect hedging to reduce expected volatility of the periods. Overall though, there is considerable time dependence, portfolio. For foreign currencies with a strong negative correlation with currencies switching from positive to negative co-movement, to equities (such as the Japanese yen in recent times), it may be and rarely dropping below the -0.2 level at which correlation better to leave open part or all of the FX exposure, if it represents effects might start to become beneficial to portfolio volatility. a volatility-reducing exposure. As a result, in a purely risk-minimising framework, the optimal hedge decision would on average: In short, with a low cost to hedging, and no expected return on currencies, we can expect volatility benefits from hedging, hedge FX risk more often than not provided the correlation of FX exposures to equity markets is for a euro base investor, hedge less on CHF and JPY and not strongly negative. more on AUD and CAD The following chart illustrates the profile of historical co-movement generally, hedge USD, as the correlation between EUR/USD iii (analogous in form to correlation) for various euro currency pairs and equities is frequently positive and seldom sufficiently relative to global equities. While historical co-movements have, negative to be risk reducing. on average, been positive for a euro base, there is considerable

Exhibit 4: Historical co-movement of various EUR currency pairs relative to global equities 0.6 USD GBP JPY CAD CHF AUD 0.4

0.2

0.0 Co-movement -0.2

-0.4

-0.6 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: ILIM, based on back-tested data from 1977–2016i

As a consequence, we can expect that, based on a purely statistical risk benefit framework, optimal hedge ratios will be dynamic in nature, reflecting the underlying risk benefit for each currency pair.

8 Foreign Currency Hedging on Global Equity Portfolios 2.3 EXPECTED RETURN IMPACT OF HEDGING

Set against the potential risk benefit of hedging, we must consider the potential return impact (opportunity cost) of hedging foreign currency exposures. With regard to evaluating the expected return and cost of a hedging strategy, the key variable components are the:

cost of carry for a hedge programme, valuation of the base currency, underlying trend in foreign currency spot prices, and transaction costs.

CONSIDERING CARRY A key factor in determining the merit of any hedging programme chosen to hedge FX risk over the same time frame. Therefore, is the carry cost associated with hedging the foreign FX exposure. we should be less inclined to hedge if our base interest rate is low versus our foreign asset mix of interest rates, and hedge If we wish to short a currency subject to higher domestic interest more if the situation is reversed. rates than our base currency, then over time, we can expect to pay the difference in the respective interest rates (or some The time evolution of carry from a euro base for the major portion thereof). While this points to an underlying inefficiency currencies is shown below, and we can see it is both time in FX markets, it is a well-documented and persistent effect, and dependant and currency specific. While we may be getting comes through in our research. It can be demonstrated that paid well to hedge JPY historically, there would have been carry Japanese-based investors would have paid a significant price in headwinds to hedging GBP. The compressed yield environment return (albeit with lower volatility) if they had chosen to hedge following the Global Financial Crises means that carry has been foreign exposures, given the low level of their base interest a less significant driver, but we are starting to see a divergence rate. Meanwhile, Australian investors would have received a in global developed interest rates once again. large performance uplift (due to high domestic rates) if they had

Exhibit 5: Time evolution of carry from euro base for major currencies

0.06 0.04 0.02 0

-0.02 -0.04 -0.06 -0.08 GBP -0.10 USD -0.12 JPY -0.14 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

Source: ILIM, based on back-tested data from 1977–2016i

Foreign Currency Hedging on Global Equity Portfolios 9 VALUATION One aspect of risk in an international equity portfolio is valuation risk, and this applies both to equity and FX exposures. For FX exposure, the valuation measure used is derived from the principle of Purchasing Power Parity (PPP). Essentially, if your base currency is deeply undervalued based on a fundamental measure such as PPP (the principle of one price), then there is a material risk that your base currency may appreciate against most, or all of your FX exposures at the same time. This would negatively impact your portfolio.

We allow an adjustment for the size of Current Account Balance (in the manner of Fair Equilibrium Exchange Rate models⁶), and then standardise the resulting valuation level taking into account historic levels for that currency and other currencies.

Versus the euro (DEM) base, we consider the valuation signals below. Deviations from parity can persist for some time (see yen, ‘80s–2000s). Based on this signal, we would be more likely to hedge Japanese yen back into euro in 1999 and 2000, and more likely to leave exposure to the Japanese yen open in 2007, on the basis that it was likely to experience a mean-reverting appreciation. Exhibit 6: Time evolution of valuation from euroi base for major currencies

3 GBP 2 USD JPY Cheap 1

0

-1

-2 Expensive

-3 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

Source: ILIM, based on back-tested data from 1977–2016i

MOMENTUM Applying a momentum factor is known to add value in many quant strategies, including FX alpha, and helps to avoid value traps where straight valuation readings are not responsive to new information impacting the market. Our research supports using a medium-term momentum signal based on 12-month returns with a linear fade. Shorter-term momentum is susceptible to excessive reversals, while longer-term momentum can lose persistence. Therefore, a medium-term signal demonstrates superior forecasting ability, allowing for transaction costs.

10 Foreign Currency Hedging on Global Equity Portfolios 2.4 COMBINING FX FACTORS

We have expressed the systematic returns of FX characteristics carry, valuation and momentum by creating pure FX portfolios based on these criteria and modeling their historical return profiles. While each of the factors delivered strong stand-alone performance over the full research sample, they also exhibited attractive diversification benefits when set against the return profile of international equities. Over longer time frames, these factors are largely uncorrelated with equities. There are also inherent diversification benefits when we combine FX risk premia, given the low-to-negative observed correlations across value, carry and momentum combinations.

This provides strong empirical support for using a weighted combination of these factors (i.e. a multi-factor model) in forecasting the expected return on currencies, and consequently the opportunity cost/return of hedging positions. Exhibit 7: FX factor cumulative return and correlation – major currencies (euro base)

2.5

2.0

1.5

1.0

0.5 Momentum Valuation 0.0

Cumulative Excess Return Carry

-0.5 Global Equity

-1.0 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Correlation 1977 – present Correlation last 15 years Momentum Carry Vaulation Momentum Carry Vaulation Carry -5.6% – – Carry 5.3% – – Valuation -43.9% 8.1% – Valuation -12.2% -65.1% – Global Equity -8.3% 9.2% -6.3% Global Equity -28.9% 39.3% -21.8%

Source: ILIM, based on back-tested data from 1977–2016i

CALIBRATION Factors are weighted with sensitivity to their relative strength and correlation characteristics to maximise portfolio Sharpe ratio in conjunction with a number of other key performance criteria. These include total drawdown (TDD), maximum drawdown, and the ratio of excess return to total drawdown (ER/TDD).

Foreign Currency Hedging on Global Equity Portfolios 11 PART 3: KEY PERFORMANCE OUTCOMES

We modelled the dynamic hedge process historically, calculating multi-factor FX exposures, expected volatilities and correlations at each monthly observation, to create an expected Sharpe-optimal set of hedges. Performance was then contrasted with un-hedged and fully hedged equity benchmarks.

We found that the dynamic hedging solution outperformed both the 0% and 100% hedge approaches in terms of both Sharpe Ratio and ER/TDDii. This was true for both the euro and average across base full sample tests. The Sharpe ratio increases from 0.35 to 0.54 in the case of the EUR investor and similarly improving from 0.41 to 0.54 for the average base investor.

In terms of volatility reduction, the dynamic solutions almost matched a 100% hedge on a straight average across the bases, but with a reduced volume of hedging. Therefore, tracking error is reduced versus the unhedged benchmark. Exhibit 8: Performance summary – euro and averages across FX bases and regional variability

Performance Summary 1977 ‒ 2015 EURO Base Average Across FX Base Metric Unhedged 100% FX Dynamic Unhedged 100% FX Dynamic MSCI World Hedged Hedge MSCI World Hedged Hedge MSCI World MSCI World Total Drawdown 62.0 38.8 34.7 53.1 40.8 36.1 ER/TDDii 0.04 0.07 0.09 0.05 0.07 0.09 Max Drawdown -54.2% -49.9% -45.0% -52.3% -50.4% -46.9% Sharpe Ratio (3%) 0.35 0.45 0.54 0.41 0.45 0.54 Beta 1.00 0.79 0.84 1.00 0.79 0.86 Tracking Error ‒ 7.4% 5.6% ‒ 7.7% 5.4% Information Ratio ‒ 0.10 0.35 ‒ -0.01 0.23 Annualised Alpha ‒ 0.7% 2.0% ‒ 0.0% 1.3% Annualised Return 9.8% 10.5% 11.8% 10.1% 10.1% 11.4% Volatility 15.6% 13.8% 13.8% 15.2% 13.8% 13.9%

Source: ILIM, based on back-tested data from 1977–2016i.. Past performance is not a reliable guide of future performance.

For the euro base tests, the dynamic model beats hedged and un-hedged on all metrics, with the exception of volatility, where it matches a 100% hedge. Against average FX bases, total drawdown, Sharpe ratio and maximum drawdown are all enhanced for the dynamic model. Volatility is 13.9% v 13.8% for fully hedged, and again, beta comes out higher at 0.86, versus 0.79 for an 100% hedge. This may relate to positive beta associated with FX carry.

12 Foreign Currency Hedging on Global Equity Portfolios As exhibit 9 demonstrates below, we see the dynamic hedge process offering robust risk-adjusted improvements across all base currencies tested over the full research sample. In addition, the dynamic model improves Sharpe ratios across all base currency positions vs. unhedged and fully hedged scenarios. We also see additional risk benefit in terms of lower average drawdowns across all base currencies for the dynamic model vs. alternative approaches. These results reflect not just the improved risk outcomes offered by the dynamic approach, but also the superior return experience due to positive exposure to FX return drivers in determining the dynamic model's optimal hedging ratio per currency base. Exhibit 9: Sharpe ratios and maximum drawdowns by FX base

0.60 0%

0.50 -10%

0.40 -20%

0.30 -30%

Sharpe Ratios 0.20 -40% Maximum drawdown

0.10 -50%

0.00 -60% USD JPY GBP CHF AUD CAD USD JPY GBP CHF AUD CAD base base base base base base base base base base base base

Unhedged 100% FX hedged Dynamic FX Unhedged 100% FX hedged Dynamic FX MSCI World MSCI World hedge MSCI World MSCI World hedge

AVERAGE HEDGE RATIOS Overall, we see an average hedge ratio of approximately 73% for the euro base, with a meaningful level of time variation and 0–100% range for a US dollar hedge ratio. Exhibit 10: Average hedge ratios for the EUR base and the specific USD hedge for the EUR base Average hedge ratio (euro base) USD hedge ratio (euro base) 100% 100%

80% 80%

60% 60%

40% 40% Hedge Ratio

EUR Hedge Ratio 20% 20%

0% 0% 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Weighted average hedge ratio Hedge ratio

Source for all charts: ILIM, based on back-tested data from 1977–2016i

Foreign Currency Hedging on Global Equity Portfolios 13 Across all the bases, we saw the following average hedge ratios, with only JPY below a 50% hedge on average. This is likely driven by the negative carry cost associated with hedging back into JPY, and the fact that for much of the sample, JPY has been above average in valuation terms. By a small margin, the euro dynamic model sees the highest historic average hedging ratio.

Average Hedge Ratio EUR USD JPY GBP AUD CAD CHF (% of FX Base) 73% 63% 35% 58% 70% 72% 58%

Source: ILIM, based on back-tested data from 1977–2016i

3.1 DYNAMIC HEDGE DOWNSIDE PROTECTION

Overall, hedging improves client outcomes by increasing the likelihood of median outcomes. In other words, there are more observations around the central peak of the distribution. Exhibit 11, below, sets out the distribution of 3-year (overlapping) return intervals across all base currency perspectives, comparing a fully hedged portfolio with the unhedged benchmark. Looking at this time horizon, the benefits of hedging in terms of reducing tail risk can be seen, i.e. there are fewer observations at the extremities. DISTRIBUTION OF 3-YEAR RETURN OUTCOMES Exhibit 11: Distribution of 3-year return outcomes across all bases 300 Negative 3-year return outcomes 250 No hedge 100% hedge 200 Dynamic hedge 150 Frequency 100

50

0 0.0% 5.9% -6.0% 11.9% 17.9% 23.8% 29.8% 35.7% 41.7% 47.6% 53.6% 59.5% 65.5% 71.4% 77.4% 83.4% 89.3% 95.3% -53.6% -47.6% -41.7% -35.7% -29.8% -23.8% -17.9% -11.9% 101.2% 107.2% 113.1% 119.1% 125.0% 131.0% 136.9% 142.9% 301.7%

Source: ILIM, based on back-tested data from 1977–2016i

14 Foreign Currency Hedging on Global Equity Portfolios DYNAMIC MODEL: SHARPE RATIO BENEFITS Exhibit 12 below provides perhaps the most compelling support for hedging FX exposure, whether statically or dynamically. The 100% hedged scenarios show higher average Sharpe Ratios across the 14 samples, but what is more convincing is the greatly reduced variability in the Sharpe Ratio outcome. Hedging reduces the variability, but not the mean of likely outcomes, by applying even a static 100% hedge. The dynamic hedge solution actually reintroduces some variability into the outcome Sharpe ratios, but the variability is all to the upside. Exhibit 12: Sharpe Ratio by FX base: Half 1 / Half 2 splits 0.9 0.8 0.7 0.6 0.5 0.4

Sharpe Ratio 0.3 0.2 0.1

0 .H2 .H2 .H2 .H1 .H1 .H1 .H2 .H2 .H2 .H1 .H1 .H1 .H2 .H2 .H2 .H1 .H1 .H1 JPY JPY JPY JPY JPY JPY GBP GBP GBP GBP GBP GBP CHF CHF CHF CHF CHF CHF EUR.H2 EUR.H2 EUR.H1 EUR.H2 EUR.H1 EUR.H1 USD.H1 USD.H1 USD.H2 USD.H1 USD.H2 USD.H2 CAD.H2 CAD.H1 CAD.H2 CAD.H1 CAD.H2 CAD.H1 AUD.H2 AUD.H2 AUD.H1 AUD.H2 AUD.H1 AUD.H1

No hedge 100% hedged Dynamic FX hedge

Source: ILIM, based on back-tested data from 1977–2016i

Key insights:

Looking over this time horizon, the benefits of hedging in terms of reducing tail risk can be seen, i.e. fewer observations at the extremities.

Hedging improves client outcomes by increasing the likelihood of median outcomes, i.e. we see more observations around the central peak of the distribution.

Foreign Currency Hedging on Global Equity Portfolios 15 PART 4: CONCLUSION

The evidence we have presented demonstrates that dynamic FX hedging is beneficial for those invested in a portfolio of global equities. We found this to be the case for all the major currencies, and generally consistent over different time periods.

The evidence we have presented demonstrates that dynamic FX drivers of returns than through the 70s, 80s and 90s, we note hedging is beneficial for those invested in a portfolio of global that the greatest downside protection was experienced in more equities. We found this to be the case for all the major currencies, recent times. and generally consistent over different time periods. The dynamic hedge process delivers reduced return variability, Our proposed value-additive process sets dynamic hedge ratios superior sharp ratios and improved return/total drawdown looking specific to each FX exposure, that are responsive to evolving across all FX bases. In absolute terms, hedging offers a win-win, correlations and betas. They are also responsive to expected with the potential for lower risk and enhanced return. return, risk, and cost for that exposure. The dynamic process Overall, the dynamic hedging approach represents a very appealing comprehensively dominates both 0% and 100% hedge approaches. risk/return proposition for investors versus either an unhedged or While some of the benefits of the dynamic approach come from static FX hedge global equity portfolio/benchmark.The Dynamic return enhancement derived from the factors of carry, value and Process offers both a potential gain in return from currency factor momentum, and although these factors may now be weaker premia, while also benefiting from reduced absolute portfolio risk.

16 Foreign Currency Hedging on Global Equity Portfolios REFERENCES

1. Prajogi, Muralidhar and Wouden (2000), “An asset-liability analysis of the currency decision for pension portfolios”, Institutional Investor (Derivatives Quarterly), Winter, pp. 47-56

2. Larsen and Resnick (2000), “The optimal construction of international diversified equity portfolios hedged against exchange rate uncertainty”, European Financial Management, 6(4), pp. 479-514

3. Black (1989), “Universal Hedging: optimizing currency risk and reward in international portfolios”, Financial Analysts Journal, July/August, pp. 16-22

4. Black (1990), “Equilibrium exchange rate hedging”, Journal of Finance, 45, pp. 899-908

5. Braccia (1995), “An analysis of currency overlays for US pension plans”, Journal of Portfolio Management, Fall, pp. 88-93

6. Cline (2014), “Estimates of Fundamental Equilibrium Exchange Rates, May 2014”, Peterson Institute for International Economics, Policy Brief (PB14-16)

7. LeGraw (2015), “The Case for Not Currency Hedging Foreign Equity Investments: A U.S. Investor’s Perspective”, GMO White Paper

8. Jourovski (2011), “Currency Impact on Minimum Variance Portfolio”, UNIGESTION White Paper

i Comparison has been made of hedged and un-hedged MSCI World returns from seven major currency bases. Data is for the period 12/1977 to 06/2016. The standard MSCI World Local Return Index represents the aggregate of various local market returns. In practise we cannot directly match this return stream as we must either accept the impact of exchange rate moves on our returns, or we can hedge out FX risk and experience the impact of interest rate differentials in the form of FX-Carry. In practise a default, un-hedged investor will buy each market retaining exposure to FX moves between his base currency and the relevant foreign currency. Alternatively, an investor may choose to hedge his foreign currency exposure passively.

The Euro based returns for MSCI World, hedged and un-hedged, extend back to 1/1999, and prior to this are represented by MSCI World from a Deutschemark (DEM) base, and the hedged DEM returns are calculated by basis conversion using historic DEM/USD exchange rates and inter-bank rates. ii Performance Metrics – One of our key risk measures is Total Drawdown (TDD) At any point in time a process is either at a new high(DD=0), or it is at a certain level of drawdown DD(t) versus its previous peak. Total Drawdown is this sum over time of DD(t). TDD is sometimes referred to as the Pain Index and so the ratio of Excess-Return to Total Drawdown, ER/TDD can be referred to as the Pain Ratio, analogous to the Sharpe Ratio where the Volatility risk measure is substituted with TDD.

iii We have looked at different ways of modelling the co-movement between FX and the Equity market. Overall the relationships we see are unstable, but there is some ability to forecast co-movement. The estimator used is based on historic weekly co- movement (the beta coefficient in a no-intercept regression), daily returns containing greater noise, and monthly requiring excess time window for estimation. This co-movement is analogous in form to correlation, but where the mean levels of return are not subtracted from the calculation, and the return horizon is longer in duration. This form, and weekly sampling is chosen to maximize explanatory power over 3-month forward co-movement, and an estimation process applied to determine an appropriate shrinkage factor representing the average level of realised versus lagged co-movement.

Foreign Currency Hedging on Global Equity Portfolios 17 Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied upon as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non- infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

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