Foreign currency exposure is a by-product of international investing – by purchasing foreign assets the investor also obtains the embedded foreign currency exposure. The sharp increase in the value of the US dollar since mid-2014 has caused a big divergence between the performance of hedged and unhedged international equities. For example, over the 5-year period from 1 June 2014 to 31 May 2018, the annualised net total returns for a US investor in the 100% Hedged MSCI ACWI ex USA Index was 7.16%, versus only 3.25% for the same unhedged index. Foreign currency return is measured as the difference in the returns of an unhedged portfolio versus one hedged back into the investor’s domestic currency, so in our example for a US investor, the annualised foreign currency return was -3.91%.
Exhibit 1 plots the foreign currency return of the MSCI ACWI ex USA Index since the introduction of the euro through to May 2018. The chart illustrates that foreign currency exposure is a source of uncompensated risk. Currency has no long-term expected return, because although it is a risk exposure, it is not an economic asset for which a long-term premium exists. The annual foreign currency return has been about zero (0.08%), but the volatility has been 6.41% and the drawdown has been as high as 30%. In the weak US dollar environment from 2000 to 2011, US investors enjoyed a windfall as the foreign currency return contributed positively to the performance of international equities. The positive returns from foreign currency might have contributed to the unwillingness to address this uncompensated risk. However, since mid-2014 the cumulative foreign currency return has been about -20%, causing a significant drag on performance.
Exhibit 1: Foreign currency return of the MSCI ACWI ex USA Index (Jan. 1999 – May 2018)
Source: MSCI, Bloomberg, BNP Paribas Asset Management, as of 31 May 2018
Although there is no easy solution to address foreign currency exposures, institutional investors generally have the following three choices:
- Do nothing, i.e. maintain unhedged foreign currency exposure
- Hedge 100%, or at least some of the foreign currency exposure
- Use active currency management to vary the hedge ratio
The best solution will differ from institution to institution. The most important determining factors are the size of the foreign currency exposure and the base currency of the investor. Secondly, it boils down to the importance of risk relative to return, and cash flow management. In the following sections, we will address the available choices in more detail.
Do nothing, i.e. maintain unhedged foreign currency exposure
Doing nothing is always the easiest option, but probably only makes sense for investors who have a relatively small exposure to foreign currency. Unhedged foreign currency exposure can provide diversification benefits, particularly when the base currency of the investor is highly correlated to global equities. For example, Canadian and Australian investors benefit from unhedged US dollar exposure because the US dollar tends to appreciate in periods of equity underperformance.
In general, hedging some or all of the foreign currency risk will reduce the volatility of the portfolio. This freed-up risk budget can then be redeployed more effectively by increasing allocations to compensated risk elsewhere. Yet passive hedging creates its own problems, including generating negative cash flow when foreign currencies are appreciating, and also detracting from returns due to hedging costs. For example, due to the high interest rates in the US, hedging US dollars is currently ‘expensive’ for European investors. At the end of May 2018, a hedged euro-based investor in US dollar assets is paying close to 3% annualised on currency-forward contracts.
It is also important to note that the word ‘passive’ is misleading, in the sense that it implies no risk. In theory an institution which has a USD 1 billion allocation to foreign currencies will reduce the volatility of the portfolio by implementing a passive hedge of 50%. In practice, when the currency policy is changed from ‘unhedged’ to ‘passively hedge 50%’, the investor would be buying USD 500 million in the market of his base currency against a basket of foreign currencies. This introduces a major market timing risk. If the base currency weakens after the change is implemented, the investor will suffer substantial hedging costs when the forward currency hedging contracts settle.
For example, Exhibit 2 illustrates that between 2000 and 2011, the cumulative negative cash flow would have been as high as 40%, forcing US investors to sell international assets to cover the losses on the currency forwards. So, in our example, the investor will have to pay USD 200 million during this period. The passive 50% hedge ratio would have lowered the volatility and possibly increased the Sharpe ratio, but at a cost of USD 200 million! You can’t eat Sharpe ratio, you need higher returns. Indeed, when experiencing this significant negative cash flow, some US institutional investors who used passive hedging liquidated their passive hedging programme at the worst possible time, as the US dollar bottomed in 2011, after locking in significant losses on the short foreign currency forwards.
Exhibit 2: Drawdowns in US dollar. Passive hedged: significant negative cash flows
Source: BNP Paribas Asset Management, Bloomberg, as of 31 May 2018
One way to address the market timing risk of implementing a passive hedging programme is to delegate the timing of hedging the foreign currencies to a currency manager. The active hedging programme seeks to reduce the risk of the foreign currency exposure but varies the hedge ratios for the different currencies based on current market views to avoid negative cash flow and to generate positive returns. A successful active hedging programme should both add to the return of the portfolio and lower the volatility.
Active hedging should not be confused with an absolute return currency strategy (currency alpha). An absolute return currency strategy also seeks to generate attractive risk-adjusted return but is not linked to any actual foreign currency exposure and should be gauged against a zero benchmark. Put differently, an investor does not have to have any foreign currency exposure to invest in an absolute return currency alpha programme. Such an investment is attractive due to the uncorrelated nature of currency alpha returns to the returns of traditional assets. Active hedging seeks to generate attractive risk-adjusted returns but is specifically tailored towards the foreign currency exposure of the investor and should outperform both zero and a passive hedging benchmark.
Institutional investor portfolios typically hold a significant allocation of unhedged foreign currencies. But currencies have no specific role in institutional portfolios. Currency has no long-term expected return, because it is not an economic asset, it is just risk. Currency risk has long bedevilled investors, with many opinions and recommendations as to whether investors should hedge their currency exposure. Left unmanaged, currency exposure functions like a buy-and-hold strategy that receives zero risk premium and adds unwanted volatility to the portfolio. Passive hedging can reduce this risk and the freed risk budget can be redeployed more effectively by increasing allocations to compensated risk instead. But simply passively hedging the currency exposure can lead to large negative cash flows and introduces significant market timing risk. Active hedging is an alternative to passive hedging that seeks to reduce portfolio volatility, add returns, and minimise negative cash flows in periods in which the base currencies weaken.