Is It Prudent to Invest Overseas Without Any Currency Hedging?

FEATURE | Is It Prudent to Invest Overseas without Any Currency Hedging?

Is It Prudent to Invest Overseas without Any Currency Hedging?

By Robert Colehan and Edward Baker

s it prudent to invest overseas without any currency hedging? The simple answer is, Figure 1: DXY (Dollar Index) 1975–2015 Iwell, it depends, because every investor has a different location, base currency, investment objective, risk profile, strategy, 160 view, asset mix, etc.

140 Colehan and Baker (2011) discussed how globalization of the financial markets has brought about opportunities for wider asset 120 diversification and greater potential returns through international investment. They 100 highlighted that although investing across international markets does provide these 80 benefits, it also introduces the unintended by-product of currency risk, which can have a significant impact on investment returns. 1975–1979 1980–1984 1985–1989 1990–1994 1995–1999 2000–2004 2005–2009 2010–2014 Colehan and Baker (2013) discussed the use of currency overlay management. Source: Bloomberg Finance L.P.

For U.S. investors in particular, currency have lasted for multiple years; the two most investments. The article covers the follow- hedging is a relevant topic because of sig- recent were 1995–2002 and 1979–1985. ing questions: nificant changes in the value of the U.S. History may not repeat itself, but we may dollar compared to other currencies. For well be in for four or five years of further 1. What are the benefits of investing the past 30 years the U.S. dollar generally significant USD appreciation. overseas? has been falling (see figure 1); it bottomed 2. What is currency hedging? out some time in 2008 but then turned a Prior to this turning point, the hedging of 3. Why do some investors hedge? corner in mid-2014 and is now up by about offshore assets into USD has provided a 4. Why do some investors decline to hedge? 25 percent in mid-2015. significant negative impact because the hedges generated losses, partially offsetting What Are the Benefits of Investing Expected tightening from the U.S Federal capital gains from overseas investments Overseas? Reserve, stronger relative growth of the U.S. (depending on the hedge ratio). However, Investment portfolios often are character- economy versus its peers, increasing energy it is important to note that when fully ized by a significant and rising exposure to independence for the United States, and hedged, any gain (or loss) in a portfolio’s foreign assets, thus portfolio managers are other well-documented factors help explain underlying currency exposures is fully off- confronted with increased currency risk. why the U.S. currency is rising in relative set by a corresponding matching loss (or But why is this? value. In fact, the consensus among com- gain) in the hedge position. As a conse- mentators appears to be that we have entered quence, fully hedged portfolios effectively A typical investment fund holds around a multi-year U.S. dollar (USD) bull market. have no foreign currency exposure. It is in 40–60 percent in equities, and approximately the context of a dollar rally that this article half of that will be invested in overseas equi- Why is this important to a U.S.-based will attempt to answer the question of ties. Fixed-income holdings also will have a investor? Historically, USD bull markets whether it is prudent to hedge overseas sizeable proportion allocated overseas.

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The strategic decision to allocate a high Investor regret is an important factor when basket of currencies offering uncompen- percentage of the portfolio to international considering a possible foreign-currency sated risk. assets is probably not based upon the view hedging strategy. If the foreign currency risk that the local currency will appreciate or is ignored, investors are likely to suffer regret For this reason, an international fixed-income depreciate against other currencies. This when the local currency strengthens. On the portfolio typically has a higher hedge ratio decision is most likely based on the need to other hand, if they fully hedge they will face than we observe with higher-volatility equities. diversify the portfolio to reduce risk, or to regret when the local currency weakens. pursue higher returns than those available Investors may mitigate two kinds of risk domestically. It’s almost impossible to estimate the amount with currency hedging: capital value risk of risk attributable to currencies in an inter- and income/transaction risk. For a U.S.- What is Currency Hedging? national portfolio because the major asset based investor, capital value risk is the risk Currency hedging is any risk-management classes all have different characteristics and that the capital value of the investment will technique that seeks to reduce foreign cur- the mix of assets within these portfolios also fluctuate as a result of movements in rency exposures and lower a portfolio’s risk have different characteristics. For example, exchange rates as the value of foreign cur- due to currency fluctuations. Most inves- the amount of risk due to currency fluctua- rency is converted into U.S. dollars. If a tors dread losses from unfavorable cur- tions for an emerging-market corporate U.S.-based investor holds a yen investment rency movements more than they relish bond is likely to be quite different from that and if the USD value rises relative to the gains from beneficial ones. for a developed-market sovereign bond. yen, then measured in USD the yen investment is now worth less than before. An investor that purchases unhedged over- The relative asset class volatilities are an seas assets effectively is holding assets important consideration when making a Income or transaction risk is the risk that denominated in the foreign currency. As a decision about hedging. The relative vola- arises when a payment is due in a foreign result, the value of these assets in USD may tility of foreign exchange compared to that currency but then converted to USD. The be affected by changes in the value of the of the underlying overseas asset class needs risk is that by the time the investor receives USD relative to the value of the foreign to be considered, because it may be that the payment, the currency value of the currency. left unhedged, return volatility in an over- income generated offshore will be reduced seas asset is mainly dictated by the foreign- when it is converted back into USD due to a For example, if the USD declines against exchange risk. In this case, it may be opti- rise in the USD exchange rate. the Japanese yen and asset prices remain mal to increase hedging to reduce the unchanged, a yen-based asset rises in USD overall volatility. Thus, in general, a lower Currency hedging is important for all asset terms. Conversely, if the USD strengthens volatility asset class, such as fixed income, classes such as equities, fixed income, and and asset prices remain the same, the tends toward being fully hedged and a property. Fixed income and property gener- investment falls in value. higher volatility asset class such as equities ally are purchased for their defensive char- tends to be only partially hedged (emerging- acteristics, because income rather than From an investor’s perspective, currency market equities often are left unhedged, for capital is the major driver of their expected hedging enables the USD value of offshore reasons we will discuss later). With this in returns. Because currency changes can investments to be protected from exchange- mind, currency fluctuations can account increase portfolio volatility, it is common to rate changes. for as much as two-thirds of the volatility fully hedge these two asset classes to remove of the total return of international bonds, exchange-rate risk. With equities, it is more Protection strategies, such as passive and making them act more like stocks. There common to partially rather than fully hedge dynamic hedging, are forms of currency fore, keeping currency fluctuations to a the exposure. The decision to hedge or not hedging that reduce the risk of currency minimum via hedging can provide inter- to hedge can have a significant impact on a exposure. Managers may choose to fully national bond investors with the benefits fund’s performance. Hedging enables a fund hedge currency exposure, removing any of diversification over the long term to offset the exchange risk on assets and also impact from currency fluctuations; or they because interest-rate and inflation patterns achieve relatively standardized performance may partially hedge in order to achieve a in other countries’ bond markets differ across currency share classes. result somewhere between that of a fully from those in the United States. These dif- hedged portfolio and an unhedged portfolio. ferences cause non-U.S. bond markets to To illustrate the impact of currency hedg- The main instrument used in most hedging behave differently than the U.S. bond mar- ing, it is useful to compare hedged versus strategies, and the one used for examples in ket. As a consequence, an unhedged inter- unhedged returns over the most recent this article, are forward foreign-exchange national bond investment might actually USD bull and bear cycles and over the full contracts. A common expiration period for increase the risk of a portfolio, because an term using the Dollar Index. These com- a forward contract is 90 days, though longer investment portfolio of unhedged interna- parisons are shown in table 1, which shows and shorter time periods are also available. tional fixed-income securities is basically a returns of the hedged and unhedged MSCI

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EAFE Index over the last full USD business Even with the statistical benefits detailed Consideration also must be given to the cycle. We chose the MSCI EAFE Index above in mind, currency hedging is not investment time horizon. Currencies are because it is an equity index that captures suitable for every international investor. more prone to diverge from equilibrium in large- and mid-cap representation across the short term than over the long term. developed-market countries worldwide Why Do Some Investors Hedge? Given the higher currency volatility over excluding the United States and Canada. Recall that every investor is unique and has shorter or medium horizons, hedging may different reasons for deciding to hedge (or help to eliminate noise. Hedging currency The numbers speak for themselves; the stark not). Either choice is an important strategic exposures may allow investors to attain difference in risk-adjusted returns for a decision because currency can have a sub- their goals if they value stability and are U.S.-based asset manager, depending on the stantial impact on risk and return in global seeking to reduce short-term downside risk. prevailing foreign-exchange environment, investment portfolios. shows that currency hedging can be quite With regard to cost, on the whole, currency important. With the benefit of 20/20 hind- Currency hedging can be used to alter the forwards are very liquid and therefore are a sight, hedging overseas currency exposure risk profile of an international investment relatively inexpensive way to hedge. in a cyclical USD bull market and remain- portfolio by allowing for the possibility of ing unhedged during periods of USD weak- an increased allocation of the risk to more Pension funds hold a specific set of assets to ness is obviously the best possible strategy. profitable asset classes. Most institutional match liabilities. Almost all pension liabili- A fully hedged strategy over the past full investors have a specific risk budget for ties are defined in local currency. Investment business cycle offered only marginally better their investments. If the volatility from cur- in cross-border assets represents a mismatch risk-adjusted returns and no reduction in rencies can be removed, the risk budget can between assets and liabilities of a pension risk in this particular instance. Therefore, be re-allocated among those asset classes fund, and hedging this currency risk may an investor could be forgiven for dismissing that fall under the core competency of fund reduce the impact of this mismatch. the need to hedge over a very-long-term managers. Most investment fund managers horizon. We would counter that this is are chosen for their proven expertise in At a time of virtually zero returns from absolutely not expected to be the case. The equity or fixed-income markets, not their fixed income, an unhedged portfolio is above example uses a static hedge ratio but currency management skills, so it might basically a currency portfolio rather than a the ideal scenario would be to implement a make sense to outsource the currency bond portfolio. In effect you are getting an dynamic/active hedging program that is hedging to a specialist. asset with almost zero expected return and able to assess when to hedge and when not lots of volatility. to hedge. Furthermore, talking about long- An investor’s outlook is important; if an term investment horizons is somewhat investor believes that foreign currency will The decrease in fixed-income returns and academic: Few investors can afford to wait depreciate relative to the USD, then cur- the recent equity market turmoil justify out an entire investment cycle (in this case rency hedging may be seen as a viable solu- a strong interest in the protection of asset 13 years) to recoup large losses resulting tion to mitigate losses. returns, and this is where hedging can from currency devaluations. be useful.

Table 1: Comparison of Hedged vs. Unhedged MSCI EAFE Index Returns Why Do Some Investors Decline to Hedge? Previous USD Bull Market Like most things in life, the decision about April 1995–February 2002 Hedged Unhedged whether to hedge has a flip side, too. Annualized Return 7.87% 0.11% Standard Deviation 14.75% 14.75% So, why not hedge all equity investments? Information Ratio 0.53 0.01 Perhaps the exact currency exposure of the Last USD Bear Market underlying investment is hard to deter- March 2002–March 2008 Hedged Unhedged mine. For example, many large interna- Annualized Return 2.86% 10.53% tional companies in which a fund might Standard Deviation 13.66% 13.24% invest are not pure plays on the country in Information Ratio 0.21 0.80 which they’re listed but international in Full Cycle their own right. Hedging such holdings isn’t necessarily straightforward. April 1995–March 2008 Hedged Unhedged Annualized Return 5.51% 4.93% Or a fund may be invested in emerging Standard Deviation 14.22% 14.14% markets because the investor wanted some Information Ratio 0.39 0.35 currency exposure in the first place (though

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with the recent large flows into emerging Cash flow implications for the portfolio might markets some funds have begun to hedge these exposures, because investments in “be one reason that some pension funds do not developing economies now account for a hedge currency investments. The forward contract greater proportion of their portfolios). But would be in favor of the investor if the local currency generally speaking, international investors expect emerging-market currencies to depreciates with respect to the foreign currency, strengthen as the stature of these econo- and vice versa if it appreciates. mies improves. For that reason, they’re less ” inclined to hedge such positions.

Sometimes those currency fluctuations can positive) cash flow needs as the forward There are many types of participants in the be beneficial to investors. In such cases, currency positions are rolled forward. The currency markets and they have different currency hedging would counteract any situation becomes somewhat more risky for views on how gains and losses are defined. profits due to favorable movements in the portfolios holding illiquid hedged assets. In For example, one participant may define exchange rate. such a case, a losing hedge position will returns relative to a benchmark, another produce negative cash flows that may not may judge returns as a total return percent- If an investor believes that a foreign cur- be recoverable immediately in terms of age, another as cash profits and losses, and rency will appreciate relative to the USD, realizable value of the hedged assets. Cash others may have completely different then investing in unhedged securities is flow implications for the portfolio might be investment time horizons or measure probably more suitable. In this case, if the one reason that some pension funds do not returns after adjusting for risk. Some seek outlook proved to be correct, the investor hedge currency investments. The forward nonmonetary gains (e.g., central banks or would receive returns on the underlying contract would be in favor of the investor if corporate transfers), and others seek a security and gains on the currency. the local currency depreciates with respect return independent of the currency trans- to the foreign currency, and vice versa if it action (e.g., mergers and acquisitions). The Other reasons for not hedging currency appreciates. If there is a negative cash flow fact that participants have these often con- exposures may include lack of knowledge effect from the forward contract, underly- flicting objectives (e.g., nonprofit-motivated or expertise. Investors may be unaware that ing investments might need to be sold or investors create profit opportunities for the risk exists, or they may know that it extra cash may need to be paid to settle profit-motivated investors) may not result exists but believe it is trivial. losses. However, an outflow of cash is in a zero-sum return for a trade in the cur- merely the response to an unrealized currency, and it therefore can be argued that it Investors may believe that currency hedging rency gain in the portfolio. is possible to generate positive returns from costs too much. On the whole, currency for- currency trading. wards are very liquid and offer a relatively Whether currency hedging is a zero-sum inexpensive way to hedge. However, for game is a continuous debate that entertains Other reasons not to hedge include the risk underlying currencies that are less liquid, the questions of whether one participant’s that the valuations for the hedging instru- such as those for emerging markets, hedging currency gain is another’s loss and whether ments may not accurately reflect the valua- foreign-exchange exposure may be more transaction costs make it a negative-sum tions for the physical securities on which costly and less efficient. These higher costs game. the hedge is based, due to timing or pricing have the potential to diminish returns over variations. The volatile nature of foreign- time. Costs associated with hedging cur- One argument holds that the impact of cur- exchange markets may create slippage rency may include bid/ask spreads, carrying rency exposure is a wash over the long term between the losses (or gains) on a foreign- costs, and margin. Investors should evaluate as currencies go through offsetting weaken- exchange hedge and those from the foreign- whether the cost of a hedge outweighs the ing and strengthening cycles. This may be exchange-related gains (or losses) on the currency’s potential downside risk. correct over a very long period, say 10 years underlying physical securities. or more, but investment horizons are nor- Cash-flow mismatches are also a potential mally much shorter, and therefore the Conclusion downside of hedging. Currency hedges may impact of currency fluctuations should not Currency management can play an import- produce cash flows independent of the be ignored. Few pension funds are likely to ant part in portfolio management, particu- assets being hedged. The change in value of be willing to ride out a large short-term larly as investors access a greater range of hedged assets attributable to exchange rates currency move resulting in a significant international investments. Hedging can should approximately offset the change in loss. Such large devaluations/revaluations help to lower risk in a portfolio and the the value of the hedge itself, but the hedge can sometimes lead to very-long-term position may create interim negative (or unrecoverable losses. Continued on page 58 ➧

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IS IT PRUDENT TO INVEST OVERSEAS ... hedging; however, are the costs, including San Francisco. He served as editor-in-chief Continued from page 29 cash flow-related costs, worth the risk of IMCA’s Journal of Investment Consulting reduction? and now serves on the publication’s editorial decision to hedge or not to hedge often advisory board and that of IMCA’s Investments depends on the characteristics of the asset Regret enters the framework. If we don’t & Wealth Monitor. He earned a BA from class of the investment and the risk and hedge and don’t have a view, how much regret the University of South Florida and an return objectives of the particular investor. will we suffer? We want to minimize regret. MA in mathematics from the University of California, Berkeley, where he completed Investors in international shares may be This would suggest an active hedging policy. doctoral work in mathematics and was willing to accept some currency risk and a Gardner and Wuilloud (1995) proposed a Regents Fellow. Contact him at higher level of portfolio volatility in that a 50-percent fixed hedge is in some [email protected]. exchange for a greater potential return. For sense the hedge of least regret. Active hedg- more defensive asset classes such as prop- ing should reduce regret even further, in References Colehan, Robert, and Edward D. Baker. 2013. Currency erty and fixed interest, however, hedging part due to the delegation effect. Overlay Management: It’s All about Beliefs and may be a better long-term portfolio man- Objectives. Investments & Wealth Monitor 28, no. 3 (May/June): 11–17. agement strategy. Robert Colehan is senior portfolio manager ———. 2011. Foreign Exchange: More Than a By-Product. at The Cambridge Strategy in London. He Investments & Wealth Monitor 26, no. 6 (November/ December): 40–43, 47. So, is currency hedging prudent? To answer earned a BA with honors in economics from Gardner, G., and T. Wuilloud. 1995. Currency Risk in this question, consider whether the risks of City of London Polytechnic. Contact him at International Portfolios: How Satisfying is Optimal Hedging? Journal of Portfolio Management 21, no.3 international investing are fully understood. [email protected]. (spring): 59–67. If not, prudence suggests taking out an insurance policy, in this case currency hedg- Edward D. Baker is executive chairman at ing. High risk aversion normally leads to The Cambridge Strategy in London and

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