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 m n s combinations of the respective equity or fixed income indices. n e e All of our data are gross of fees and exclude transaction costs. In t e ms addition, we have focused entirely on index data so the impact of fully hedged returns relies on each currency’s weights in the
benchmarks. In practice, an investor’s portfolio could be more home biased or have different active views on regions that would affect the sizing of hedges and the outcome. However, e e t e ms we believe using standardized, transparent benchmarks is an adequate baseline approach. Rolling 3Y, Annualized Within each currency, we calculated a monthly series of relative returns of unhedged minus hedged indices for different rolling m n s periods to then obtain performance and volatility. While this is n e e t e ms a straightforward approach, very often we see results presented for the entire analysis period or one to two subperiods, which suffer from bias to the start date chosen and mask entry point risk. Given our risk focus, we think looking at rolling volatility can give investors an idea of times when risk may be higher/lower than what is masked by a single, full period summary number. e e t e ms Selected results are presented in the exhibits and expanded in the 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. m n s For the remainder of the paper, references in exhibits will be n e e t e ms labeled with a currency code only, but it represents the return of the underlying index. Hence, if we are talking about equities and label a data point or series “USD,” it means the US dollar return of the MSCI World Index or “USD H” for the hedged USD return of the MSCI World Index. Similarly, in fixed income, e e USD would be the Bloomberg Barclays Global Aggregate Index t e ms and USD H would be the hedged version of that index.
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 e 1Y Rolling "win-loss" ("win") rolling periods, which would be a more typical strategic hedging AUD - AUD H 38 time horizon in practice. CAD - CAD H 50 With this in mind, we think it is more constructive to approach CHF - CHF H 40 currencies from a risk viewpoint for equity portfolio construction EUR - EUR H 47 decisions. In other words, does removing currency risk lower GBP - GBP H 45 a portfolio’s volatility? At first glance, removing the effect of JPY - JPY H 53 currencies should lead to lower volatility. However, this overlooks USD - USD H 50 that the interaction between equity and currency returns will also
drive the volatility. % Unhedged outperforms Looking at 3-year rolling volatility we can see periods where e 3Y Rolling "win-loss" ("win") hedging actually increases risk (Exhibit 3) for AUD, CAD, and AUD - AUD H 45 EUR-based equity investors. While this happens especially in CAD - CAD H 55 times of stress (i.e., 2008–2009) it also appears elsewhere in CHF - CHF H 33 the time series. By hedging, we are removing assets (in this case EUR - EUR H 51 currency) that can provide diversification benefits. The Global GBP - GBP H 42 Financial Crisis helps illustrate this further. Taking the AUD as JPY - JPY H 63 an example, both global equities and the Australian dollar fell at the same time “safe haven” currencies such as the JPY, CHF, and USD - USD H 53 the USD strengthened (to a certain extent) in this period of stress. e % Unhedged As a result, with hedging in place, the AUD-based global investor outperforms e 5Y Rolling "win-loss" ("win") is removing the “safe haven” diversification effects and therefore obtaining a more volatile asset than by remaining unhedged. AUD - AUD H 41 This can be seen in the right panel charts of Exhibit 3, where CAD - CAD H 50 the correlation of hedged equities to the local currency spikes CHF - CHF H 21 higher relative to unhedged equities. As a final point on equities, EUR - EUR H 57 multinational companies also undertake FX hedging programs, GBP - GBP H 38 which further complicates measuring the effect of a hedging JPY - JPY H 69 overlay program. USD - USD H 54
Disentangling this effect will require deep knowledge of the As of December 2017 company fundamentals and analyzing individual historical Source: Bloomberg, FactSet return patterns to gauge if a given stock is already acting as an FX-hedged return series due to the hedging activities of the company itself. This is not an issue in fixed income, where a given bond is representing a cash flow stream in a determined currency. 5
Exhibit 3 Currency-Hedged Equities Can Have Higher Volatility in Certain Cases 3Y Rolling Volatility 3Y Rolling Correlation n e t n n e te t n e te t
3Y Rolling Volatility 3Y Rolling Correlation n t t n e te t n e te t
3Y Rolling Volatility 3Y Rolling Correlation n t t n e te t n e te t
As of December 2017 CAD hedged returns are using the local index return. Correlation charts are computed using the monthly changes in the nominal narrow effective exchange rates and the unhedged/ hedged returns as labeled. Source: BIS, Bloomberg, FactSet, Haver Analytics 6
Exhibit 4 Fixed Income: Structurally Higher Hedged Global Fixed Income Has Some Performance Volatility of a Currency Can Advantages, but Results Are Inconclusive For the period 1987–2017, monthly observations. Blue = unhedged Justify Hedging outperforms; [yellow] = hedged outperforms % Unhedged From a performance perspective, hedged global fixed income outperforms shows some advantages versus unhedged, but this is not strong e 1Y Rolling "win-loss" ("win") enough to be conclusive in all currencies and in terms of rolling AUD - AUD H 37 periods (Exhibit 4). Importantly, this assertion relates to fully CAD - CAD H 41 hedged passive, costless indices. CHF - CHF H 41 EUR - EUR H 45 In practice, we think active currency management in fixed income portfolios can add value, but that topic is beyond the GBP - GBP H 40 scope of this research. JPY - JPY H 51 USD - USD H 47 However, from a volatility perspective hedging FX leads to lower volatility for all currencies we studied. This follows from % Unhedged the observation that local fixed income returns have lower outperforms e 3Y Rolling "win-loss" ("win") volatility than the FX returns have. For example, US bonds have AUD - AUD H 41 a historical volatility of 3.7% and the USD effective exchange CAD - CAD H 35 rate has 5.4% for the period 1987–2017. Japanese bonds have a volatility of 3.4% and the JPY effective exchange rate has 8.4%7. CHF - CHF H 28 So, when we look at global fixed income markets the mix of EUR - EUR H 44 currencies will introduce fluctuations, leading to higher volatility GBP - GBP H 35 for unhedged versions of global fixed income (Exhibit 5). JPY - JPY H 58 Thus far, we have evaluated fully hedged indices. From our USD - USD H 51 data, we can draw an interesting observation related to the pace e % Unhedged of volatility reduction related to the share of a fixed income outperforms e 5Y Rolling "win-loss" ("win") portfolio that is hedged. The reduction in volatility slows down after approximately hedging 50% of the fixed income AUD - AUD H 29 portfolio (Exhibit 6). The improvement in risk reduction is not CAD - CAD H 23 as significant as one moves from 50% to 100% hedging versus CHF - CHF H 13 moving from unhedged to 50% hedged. In other words, about EUR - EUR H 43 60% hedging achieves three-fourths of the possible risk reduction. GBP - GBP H 37 We approximated the percentage hedge by calculating weighted JPY - JPY H 76 returns of the unhedged and fully hedged indices and moving USD - USD H 48 these weights incrementally.
As of December 2017 The results are driven in part by the interaction of the weight Source: Bloomberg of each currency in the index and the unhedged volatility. For instance, the USD is the largest weight and has the flattest line— reflecting slower rate of risk reduction, even at 0% hedged there is already a large share of USD in the benchmark. In contrast, the AUD risk falls sharply as it has a smaller weight in the index than the USD has, meaning that a bigger proportion of FX risk is being removed as the hedge increases. Overall, we think these observations have practical implications for benchmark-aware global fixed income portfolios, as it can be used as a rough guide to think about sizing the hedges. 7
Exhibit 5 Multi-Asset Portfolios: Interaction Hedged Global Fixed Income Has Lower Historical Volatility Gets More Complex Rolling 3Y Volatility, Annualized As an approach for a basic multi-asset proxy, we ran 50/50 equity/ fixed income portfolios with monthly rebalancing. In our opinion, this provides an adequate baseline to evaluate the most basic form of multi-asset investing. We then applied the same analysis we had done separately for equity and fixed income—calculate
rolling period performance and volatility. In terms of performance, we once again cannot make a conclusive statement with regards to hedging for every period and currency (Exhibit 7). Except the cases for JPY and CHF 5-year rolling returns, where unhedged and hedged favor each currency
Exhibit 7 Unhedged vs. Hedged Performance in Multi-Asset Portfolios For the period 1990–2017, monthly observations. Blue = unhedged outperforms; [yellow] = hedged outperforms % Unhedged outperforms e 1Y Rolling "win-loss" ("win") AUD - AUD H 37 CAD - CAD H 45 CHF - CHF H 36 EUR - EUR H 46 As of December 2017 Additional currencies shown in the appendix GBP - GBP H 44 Source: Bloomberg JPY - JPY H 50 USD - USD H 51
Exhibit 6 % Unhedged Risk Reduction Rate in Fixed Income outperforms e 3Y Rolling "win-loss" ("win") t t AUD - AUD H 45 CAD - CAD H 40 CHF - CHF H 22 EUR - EUR H 48 GBP - GBP H 40 JPY - JPY H 60 USD - USD H 52
e % Unhedged e e outperforms e 5Y Rolling "win-loss" ("win") For the period January 1990 to December 2017 AUD - AUD H 34 Source: Bloomberg CAD - CAD H 26 CHF - CHF H 5 EUR - EUR H 49 GBP - GBP H 39 JPY - JPY H 75 USD - USD H 50
As of December 2017 Source: Bloomberg, FactSet 8
respectively. From a risk perspective, volatility for the entire Exhibit 8 period was indeed lower for fully hedged portfolios—generating Hedged Portfolios Can Have Higher Risk at Certain Points better risk-adjusted returns. The case of Japan and Switzerland- 3Y Rolling Volatility based investors are where we see the biggest reduction in volatility via hedging. But in the case of the USD, results were very similar in both performance and volatility. However, when looking at rolling period of volatility, we do see some instances where the hedged solutions have higher risk (Exhibit 8). We have discussed only equity and fixed income combinations, but multi-asset
portfolios can span other asset classes. The same framework can evaluate the FX impact on other assets (see callout: FX Considerations for Commodities). What are investors’ options given that most of the evidence thus far appears inconclusive with regards to a general statement about hedging as risk control? Especially, for USD-based investors the decision to hedge correctly based on past data appears as good as a coin toss. However, the structure of multi-asset portfolios allows for other tools for managing risk. Volatility Targeting: Asset Allocation as a Risk
Control Tool Risk awareness is a central feature of multi-asset portfolios, where a focus on outcomes becomes vital for evaluating results. At first glance, removing FX exposure through hedging would appear to
be a good risk mitigation tool. However, as we have outlined, this is true in fixed income investments but not in equities or in basic multi-asset portfolios. Informed by our internal research (Predicting Volatility and Dynamic Volatility Targeting), volatility targeting through
dynamic asset allocation is an effective tool for controlling risk and smoothing a return pattern.8 Hence, historical risk targets from FX-hedged solutions can be met with unhedged solutions through asset allocation. As of December 2017 To evaluate this, we took the realized long-term volatility of a CAD hedged returns are using the local index return. USD hedged 50/50 equity/fixed income blend (7% annualized Source: Bloomberg, FactSet 1987–2017) as our volatility target. We obtained equity and fixed income weekly weights through medium- and short-term volatility optimizations for the period 2000 to 2017.9 This volatility-controlled approach results in an improved Sharpe ratio: 0.24 for the hedged 50/50 blend versus 0.38 for the unhedged targeted-volatility portfolio.10 In addition, we can see a smoother volatility pattern, particularly in times of market stress (Exhibit 9). Of course, the hedged approach and volatility targeting method are not mutually exclusive. These two can potentially combine to meet other risk outcomes. However, we want to highlight that on its own, volatility control through dynamic asset allocation can be a powerful portfolio construction tool that directly seeks a risk outcome. On the other hand, currency hedging on its own is not as effective at fine-tuning a volatility target. 9
Exhibit 9 Comparing Volatility Targeting (Unhedged Blend) vs. a Hedged Blend
ee n t t
t t et
For the period May 2000 to December 2017 For illustrative purposes only. This data does not represent any product or strategy managed by Lazard. USD H uses MSCI World Local as the equity component due to data frequency. Source: Bloomberg
Conclusion FX Considerations for Commodities The impact of currency hedging in global portfolios has been Commodities have very different FX implications when debated extensively. We believe that taking a risk control compared to those of equities and bonds. Globally, the prices viewpoint to this dilemma helps frame investment decisions in a of investable commodities are quoted in USD. However, more constructive way. The flipside would be focusing on return commodities come from many different locations. Therefore, enhancement and therefore the timing of hedges. We believe that there constantly are interactions between the local currency, policies that aim to hedge to improve performance are challenging the commodity price, and the USD itself. Making sense of to time correctly, as our results show. Instead, FX specialists are these interactions requires a specialized skillset. needed if the intention is to add value through active currency In general, commodities provide a natural hedge to USD management. We also recognize that institutional or regulatory fluctuations. Since they are priced in USD, a stronger dollar constraints may force some asset allocators to fully or partially boosts the profits of commodity exporters. When the dollar hedge their exposure to meet requirements. weakens, commodity demand in non-dollar countries For asset allocators, a helpful approach would be to focus on the strengthens. With this in mind, constructing a commodities risk characteristics—rather than performance—within FX-hedged portfolio would not implement FX hedges as part of the portfolios. While some performance advantages may emerge in fundamental views. certain cases, we usually found this in our 5-year rolling period However, from the point of view of asset allocation, a analysis, which may not be practical to set up. Understanding commodities allocation must take into account the FX the interaction of the portfolio base currency with a given global translation effect. In other words, evaluating a global asset class is critical—in some cases hedging FX exposure can commodities exposure (priced in USD) as it is converted to amplify risk. If FX hedging is not an institutional requirement, an the domestic currency. It follows that asset allocators must effective method of risk control can be through asset allocation understand if their portfolio seeks an exposure to global with dynamic volatility targeting. commodities simply translated to local currency—in which case the solution is unhedged. On the other hand, if one seeks to obtain the USD-based dynamics of a commodities exposure, the solution can be to hedge and remove the FX translation effect. 10
Appendix Equity
Results for the period 1987–2017 (EUR since 1999) AUD CAD CHF EUR GBP JPY USD Local AUD H EUR H GBP H JPY H USD H Return (%) 5.3 5.5 4.7 3.1 6.8 5.4 5.6 5.6 7.8 2.5 7.3 3.5 5.9 Volatility (%) 13.2 12.6 16.7 14.2 14.7 17.4 14.7 13.7 13.9 14.0 13.7 13.6 13.7
Source: Bloomberg, FactSet
Fixed Income
Results for the period 1990–2017 (EUR, CAD, CHF since 1999) USD USD H EUR EUR H AUD AUD H JPY JPY H CHF CHF H CAD CAD H GBP GBP H Return (%) 5.9 6.1 3.9 4.2 5.9 8.5 5.0 3.9 2.1 3.0 3.1 4.9 6.8 7.6 Vol (%) 5.4 3.0 6.7 2.7 10.2 3.0 8.7 3.0 7.5 2.7 8.5 2.7 8.3 3.1
Source: Bloomberg, FactSet
Volatility is consistently lower in hedged fixed income – 3Y Rolling Volatility
11
3Y Rolling Volatility
Source: Bloomberg
Multi-Asset
Results for the period 1990–2017 (EUR, CAD, CHF since 1999) USD USD H EUR EUR H AUD AUD H JPY JPY H CHF CHF H CAD CAD H GBP GBP H Local Full Period, ann (%) 5.7 5.7 3.6 3.7 5.7 7.7 4.8 3.5 1.9 3.2 2.9 4.2 6.6 7.1 5.7 Vol (%) 8.5 7.1 8.2 6.9 9.3 7.2 11.9 7.1 10.1 6.8 7.3 6.8 9.6 7.1 7.1
Source: Bloomberg, FactSet 12
Currencies Nominal narrow effective exchange rates
Results for the period 1987–2017 (EUR since 1999) AUD CAD EUR JPY CHF GBP USD Volatility (%) 7.6 5.4 4.8 8.3 4.6 5.5 5.4
In e e em e
NEER for the euro prior to 1999 is calculated using a weighted average of legacy currencies. Source: BIS
References Brandes Institute. 2007. “Currency Hedging Programs: The Long-Term Perspective.” Gastineau, Gary L. 1995. “The Currency Hedging Decision: A Search for Synthesis in Asset Allocation.”Financial Analysts Journal, May-June 1995. Marra, Stephen. 2013. “Dynamic Volatility Targeting.” Lazard Investment Research. Marra, Stephen. 2015. “Predicting Volatility.” Lazard Investment Research. Pojarliev, Momtchil and Richard M. Levich. 2012. “A New Look at Currency Investing.” The Research Foundation of CFA Institute, 21 December 2012. Peterson LaBarge, Karin. 2010. “Currency management: Considerations for the equity hedging decision.” Vanguard. Peterson LaBarge, Karin. 2014. “To hedge or not to hedge? Evaluating currency exposure in global portfolios.” Vanguard. Statman, Meir. 2005. “Hedging Currencies with Hindsight and Regret.” The Journal of Investing. Thomas, Charles and Paul M. Bosse. 2014. “Understanding the ‘hedge return:’ The impact of currency hedging in foreign bonds.”Vanguard . 13
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Notes 1 For a comprehensive discussion of this topic see: Pojarliev and Levich (2012). 2 Gastineau (1995) 3 Statman (2005) 4 Peterson (2010, 2014), Thomas (2014), Brandes (2007) 5 The Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of global investment-grade fixed-income debt markets, including government-related debt, corporate debt, securitized debt, and global Treasury. The index is unmanaged and has no fees. One cannot invest directly in an index. 6 These would include drawdowns, tracking error, factor exposures that can arise from foreign securities, or other characteristics. 7 Volatility based on monthly returns. US bonds = Bloomberg Barclays US Aggregate Index; USD effective exchange rate = nominal narrow effective exchange rate from the Bank of International Settlements; Japan bonds = FTSE Japan GBI Local Index; JPY effective exchange rate = nominal narrow effective exchange rate from the Bank of International Settlements. Source: Bloomberg, Haver Analytics 8 Marra (2013 and 2015) 9 Methodology: asset class weights are the result of 2 independent optimizations using the MSCI World Index and the Barclays Global Aggregate Index. One optimization looks at the last 6 months of weekly returns and the other looks at the last 22 days of daily returns. Both of these aim to minimize the tracking error with a 50/50 allocation of MSCI World/Global Aggregate while targeting 7% volatility using the aforementioned time periods. Whichever optimization has the lower allocation to equities is then used in the resulting allocation. Optimizations allow +/- 0.5% volatility relative to the 7% target. There can be cases when no weights are found by the process due to volatility over/under shooting the limits, in these instances all weight is put on fixed income or equity respectively. Other sporadic missing weights values were filled with the average of the previous and next weights. 10 Based on weekly data using 50/50 local instead of USD H for equity given that USD H is monthly. Monthly Sharpe using USD H is 0.25.
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