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FX Effects: Currency Considerations for Multi-Asset Portfolios

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FX Effects: Currency Considerations for Multi-Asset Portfolios Investment Research FX Effects: Currency Considerations for Multi-Asset Portfolios Juan Mier, CFA, Vice President, Portfolio Analyst 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. 2 “The cognitive bias of hindsight is The Debate on FX Hedging in Global followed by the emotion of regret. Portfolios Is Not New A study from the 1990s2 summarizes theoretical and empirical Some portfolio managers hedge papers up to that point. The solutions reviewed spanned those 50% of the currency exposure of advocating hedging all FX exposures—due to the belief of zero expected returns from currencies—to those advocating no their portfolio to ward off the pain of hedging—due to mean reversion in the medium-to-long term— regret, since a 50% hedge is sure to and lastly those that proposed something in between—a range of values for a “universal” hedge ratio. Later on, in the mid-2000s make them 50% right.” the aptly titled Hedging Currencies with Hindsight and Regret 3 —Hedging Currencies with Hindsight and Regret, took a behavioral approach to describe the difficulty and behav- Statman (2005) ioral biases many investors face when incorporating currency hedges into their asset allocation. Why Hedge FX? In addition to academics, many industry practitioners have Foreign currencies (FX) are a means of exchange for global trans- tackled the FX hedging dilemma.4 Our study explores this actions. However, FX plays a key function in global investing both question drawing from similar methodologies and benefits from as an asset class in its own right and as a component of financial the data availability of hedged indices for both equity and fixed asset returns. Very simply, global investors need to convert foreign income, data, which to our knowledge, was not extensively avail- currency-denominated investments into their portfolio’s base able in the past. As such, we take a data-driven approach to glean currency. This activity can lead to gains or losses that may be insights from the historical risk-return profiles in equities, fixed totally unrelated to a security’s fundamentals. A hedged position income, and simple 50/50 multi-asset portfolios. can remove the losses when the currency moves adversely, but also mute gains if the currency moves favorably. Data and Methodology The analysis and results center on global developed markets equity While we recognize currency effects can be considered within and fixed income indices. Results are calculated from the point fundamental security analyses—by adjusting valuation model of view of the following developed markets currencies: US dollar parameters—it is also an important concern at the portfolio (USD), Australian dollar (AUD), British pound (GBP), Canadian construction level or for institutional asset owners. Hedging has dollar (CAD), euro (EUR), Japanese yen (JPY), and Swiss franc been a widely discussed subject for many years and interest in the (CHF). Importantly, EUR returns for both equity and fixed topic would appear to fluctuate along with major currencies’ moves. income are only available since its inception in 1999. The main We are approaching this paper by focusing on currency hedging reasons for excluding emerging markets is insufficient availability as a potential tool for portfolio risk control. While we believe that of data. Perhaps more importantly, hedging emerging markets value can be added from active currency management1 we need to currencies in practice can be more expensive and results using separate the return generation goals from the risk control objec- cost-free index data may underestimate actual results by a greater tives—as these two are competing goals. In other words, we will margin than in the developed world. look at asset returns where hedging is “passive” and there is no The time period analyzed spans almost three decades of monthly tactical timing element to put in the hedges or to take active views returns and is restricted by our availability of hedged index on certain currency pairs. 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 avail- able, 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 hypo- thetical 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 (we 3 ended up using local returns for the CAD and CHF equity Exhibit 1 cases). In fixed income, we relied on unhedged and hedged Timing Performance from Currency-Hedged Equities Can Be currency versions of the Bloomberg Barclays Global Aggregate Very Challenging Bond Index5 which goes back to January 1990. For multi-asset Rolling 1Y, Annualized results—combining equity and fixed income—we used 50/50 USD minus USDH (%) combinations of the respective equity or fixed income indices. 10 Unhedged All of our data are gross of fees and exclude transaction costs. In outperforms 5 addition, we have focused entirely on index data so the impact of fully hedged returns relies on each currency’s weights in the 0 benchmarks. In practice, an investor’s portfolio could be more -5 home biased or have different active views on regions that -10 would affect the sizing of hedges and the outcome. However, Hedged outperforms we believe using standardized, transparent benchmarks is an -15 adequate baseline approach. 1989 1993 1997 2001 2005 2009 2013 2017 Rolling 3Y, Annualized Within each currency, we calculated a monthly series of relative returns of unhedged minus hedged indices for different rolling USD minus USDH (%) 6 periods to then obtain performance and volatility. While this is Unhedged outperforms a straightforward approach, very often we see results presented 3 for the entire analysis period or one to two subperiods, which suffer from bias to the start date chosen and mask entry point 0 risk. Given our risk focus, we think looking at rolling volatility -3 can give investors an idea of times when risk may be higher/lower -6 than what is masked by a single, full period summary number. Hedged outperforms Selected results are presented in the exhibits and expanded in the -9 1989 1993 1997 2001 2005 2009 2013 2017 Appendix. We recognize there are other interpretations of port- folio risk6, but we believe using the standard deviation of returns Rolling 5Y, Annualized is a suitable approach. USD minus USDH (%) 6 For the remainder of the paper, references in exhibits will be Unhedged outperforms labeled with a currency code only, but it represents the return of 3 the underlying index. Hence, if we are talking about equities and label a data point or series “USD,” it means the US dollar return 0 of the MSCI World Index or “USD H” for the hedged USD return of the MSCI World Index. Similarly, in fixed income, -3 Hedged USD would be the Bloomberg Barclays Global Aggregate Index outperforms -6 and USD H would be the hedged version of that index. 1989 1993 1997 2001 2005 2009 2013 2017 As of December 2017 Equity: Hedging May Not Be Justified Source: Bloomberg, FactSet from a Risk Standpoint The contribution of currency effects to equity performance is useful in practice (i.e., maintaining a 30-year hedging program). an important consideration. As a result, it is tempting to view Therefore, looking at rolling periods of relative returns currency hedging as a possible return enhancer in equity portfo- (unhedged minus hedged) gives us a better sense of different lios. However, a hedging decision can have a positive or negative regimes when hedging has been effective (Exhibit 1). Not only impact depending on the direction of the currency fluctuation. do relative returns change direction, but also the spread can be This leaves portfolio managers with the added complexity of significant—exacerbating the behavioral “regret” risk of being determining hedging entry points. For example, while hedged on the wrong side of the FX hedge. USD equities slightly outperformed unhedged equities (+5.9% versus +5.6%) over the 1987–2017 period, this is not very 4 If past results are a rough guide to future behavior one could Exhibit 2 argue for hedging global equities for Swiss investors and going Summary Results for Equity: Unhedged vs. Hedged unhedged for Japanese investors based on the 3-year and 5-year For the period 1987–2017, monthly observations. Blue = unhedged return results (Exhibit 2). However, overall results are closer outperforms; yellow = hedged outperforms to “50/50” in most cases, highlighting the difficulty of getting % Unhedged outperforms the hedging decision right. This is especially relevant in 1-year 1 Year 1Y Rolling "win-loss" ("win") rolling periods, which would be a more typical strategic hedging AUD - AUD H 38 time horizon in practice.
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