Managing foreign currencies in an investment portfolio Research Insights – June 2020, LGT Economic Research “There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.” Winston Churchill Front cover: King and Queen and mixed currency on the chess board, shutterstock.com Contents 4 Executive summary 5 Introduction 6 The hedging decision-making process 20 Current and future challenges for foreign currency management 22 The next safe haven currencies 26 Appendix 4 Executive summary Investing in foreign assets is inextricably linked to investing in Similarly, if a portfolio’s base currency is considered a safe haven, foreign currency. The latter can lead to a dramatically different like e.g. the Swiss Franc that tends to appreciate when risk investment outcome between foreign and domestic investors assets sell-off, hedging (almost) all foreign currency exposure that buy the same asset. Not only will their returns differ, but is likely to be beneficial. This is because the portfolio’s assets their investment risk will too. Global investors will therefore will co-move with the foreign currencies associated with those have to decide how to deal with foreign currency exposure in an assets and thus add risk. On the other hand, if an investor’s base investment portfolio. currency is pro-cyclical and thus shows a positive correlation to global risk assets, having up to 40% foreign currency exposure By hedging currency risk, the foreign investment’s volatility will actually reduces risk. This is because it will give exposure to approximate the risk profile of the asset in domestic currency. save haven currencies (primarily USD given the high share of However, doing so will require the investor to forego the return USD-denominated assets in global benchmarks). on the foreign money market for their domestic money market rate, which can come at a cost or a benefit, depending on the From a cyclical perspective, hedging has a particularly strong sign of the two money markets’ interest differential. impact during times of economic crisis such as the current global recession induced by the spreading of COVID-19 as asset Conditional on how one thinks about the risk-return profile of price correlations become more aligned. Going forward, it may currency, one will thus tackle the hedging question differently. be desirable to tilt hedging ratios to the higher end of the usual Unsurprisingly, neither practitioners nor academics are therefore range for a variety of reasons such as a high volatility and low unanimous on how to manage currencies in a portfolio. Some return environment, prevalence of unconventional monetary argue that currencies do not earn a reliable risk premium but policy or the prospects of sustained lower hedging costs. only feature volatility. An unhedged asset will thus have the same risk premium as a hedged investment, but with higher In cycles to come, potentially novel safe havens should be volatility (i.e. a lower risk-adjusted return). Others find that if considered in the hedging process. Currently, there are three currencies and asset-prices tend to mean-revert, hedging may globally established safe haven currencies: USD, CHF and not reduce, or worse, even increase volatility in the long-term JPY. Our macro criteria-based catalogue identifies additional and result in higher transaction costs. currencies that may develop similar anti-cyclical properties in the more distant future. Viable candidates range from various We argue that the optimal way to deal with foreign currency Gulf currencies to prominent Asian and European currencies. in a portfolio changes with the underlying asset-currency Although it remains doubtful that the identified currencies will correlation and will thus vary across portfolios and base become global safe havens anytime soon, most of them have currencies. Generally speaking, low volatility assets should already served as regional ones in the past. Global investors have a high hedge ratio. For multi-asset portfolios that include can put such information to good use when setting up their alternative investments, somewhat higher hedge ratios appear portfolio hedges by taking selective exposure to regional safe adequate too. havens in the context of broader asset allocation. 5 Introduction Investing in foreign assets is inextricably linked to investing argue that currencies do not earn a reliable risk premium but in foreign currency. For example, a US investor that buys a only feature volatility.1 An unhedged asset will thus have the European stock will earn a return that is composed of the same risk premium as a hedged investment, but with higher return of the euro-denominated stock plus the change in the volatility (i.e. a lower risk-adjusted return). Others find that EUR/USD exchange rate. Therefore, investing abroad means if currencies and asset-prices tend to mean-revert, hedging having exposure to two different sources of risk and return: may not reduce, or worse, even increase volatility in the long- the underlying asset and the exchange rate. Furthermore, the term and result in higher transaction costs.2 Others try to walk impact of the latter can be large. Consider the return of an the middle path and simply hedge half of their portfolio or identical global multi-asset portfolio for a Japanese investor and implement another universal hedge quota.3 Lastly, there are a British investor during the financial crisis in 2008 as shown in studies that find varying hedge ratios across base currencies Table 1. While the Japanese investor lost almost 40% in that optimal4, depending on the correlation between the asset at year, their British equivalent gained about 4% on the very same hand and the risk profile of the currency. portfolio. To some investors, foreign exchange is thus primarily a byproduct of international investing and an unwarranted Based on theoretical and empirical reflections, we tend to additional layer of risk. To others, it constitutes an extra source agree with the last lineage. Over the following pages, we will of return. However, to any investor, it poses a fundamental show what underpins our conclusion, give more insight on question: How to deal best with foreign currency in a portfolio? the key elements that shape our thinking about hedging and elaborate on how investors should take them into account when Indeed, there are quite a few important factors that shape making their own hedging decision. Specifically, we will explore the decision making process of an international investor. Most the mechanics behind hedging, outline the relevance of the importantly, the investment aim (return generation versus risk underlying asset’s volatility on the hedging decision and analyze reduction), the asset at hand, the investor’s base currency and how a portfolio’s base currency can lead to changes in the their investment horizon. Due to this variety of factors and optimal foreign currency exposure. We will then explore current preferences as well as conflicting aims that all influence the and upcoming challenges investors might face with regard to viability of hedging, neither practitioners nor academics are hedging and lastly, try to identify currencies that might gain in unanimous on how to manage currencies in a portfolio. Some relevance in the future for an investor’s hedging decision. Table 1: Historical annual performance of a global mixed asset portfolio (60% equities/40% bonds) in various base currencies 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 p.a. in USD 14% 10% -25% 19% 9% -3% 9% 10% 2% -3% 4% 16% -7% 17% 3.8% in EUR 2% -1% -21% 16% 17% 1% 7% 5% 16% 8% 7% 1% -2% 19% 4.7% in GBP 0% 8% 4% 6% 13% -2% 4% 7% 8% 2% 24% 6% -1% 12% 6.7% in CHF 5% 2% -29% 16% -1% -2% 6% 7% 14% -3% 6% 11% -6% 15% 2.0% in JPY 15% 3% -39% 23% -5% -8% 22% 34% 16% -3% 1% 12% -9% 16% 3.4% in AUD 6% -1% -5% -8% -4% -3% 7% 27% 11% 9% 5% 7% 3% 17% 4.5% in KRW 5% 11% 1% 10% 6% -1% 1% 8% 6% 3% 7% 2% -3% 21% 5.4% in CNY 10% 3% -30% 19% 5% -7% 8% 7% 4% 1% 12% 8% -2% 18% 2.7% in SGD 5% 3% -25% 16% 0% -2% 2% 13% 7% 3% 6% 7% -5% 15% 2.6% Source: Refinitiv, LGT Capital Partners 1 Cf. Perold and Schulman (1988) and Eun and Resnick (1988) 2 Cf. Froot (1993) 3 Black (1989) considers a universal hedge ratio of 77% appropriate in international equity portfolio whereas a 2004 survey by Russel/Mellon among institutional investors in major markets showed that the majority prefers to hedge in three distinct tranches, either zero, 50% or 100%. 4 Cf. Campbell et al. (2010) 6 The hedging decision-making process Currency risk is not a new phenomenon. Although volatility was Although the mean-reversion argument is theoretically sound, generally lower in the past due to the gold standard, changes in practice, simply relying on PPP can be very risky. Numerous in gold supply or coinage devaluation could even then create assumptions underpinning PPP are not given in reality and fierce spikes in exchange rates. Since the prevalence of floating mean-reversion is often strenuously lengthy. For example, exchange rates, bursts of volatility have increased in frequency. the notoriously appreciating CHF has failed to mean-revert A few recent examples are the abandonment of the EUR/CHF to some measures of PPP-implied equilibrium values for more floor or the GBP slump following the Brexit referendum as well than 20 years. That’s a long period of continued exposure to as the 2019 Argentine peso sell-off.