The conundrum for international investing
Foreign currency exposure is a by-product of international investing. When obtaining global assets exposure, investors also acquire the embedded foreign currency exposure. In effect, unhedged foreign equity portfolios can be categorized into two portfolios. Portfolio #1 consists of a locally denominated market-weighted portfolio of foreign equities. Portfolio #2 is positioned long a basket of foreign currencies against the US dollar (with the weights of the basket determined by the weights of the equities in portfolio #1). Exhibit 1 outlines the composition of the proto-typical US institutional investor portfolio. We assume that the 60% allocation to equities is divided across US equities (27.5%), non-US developed economy equity (25%) and emerging market equities (7.5%). The 32.5% allocation to non-US equities is a source of significant foreign exchange risk (portfolio #2). Schmittmann (2010) estimates that currency risk contributes up to 40% to the overall risk of an equity portfolio.
The sharp increase in the value of the US dollar since mid-2014 of more than 25% has caused a big divergence in the performance of US equities and unhedged international equities due to the depreciation of foreign currencies against the US dollar. Put differently, while portfolio #1 did well, portfolio #2 experienced a 25% loss as the US dollar surged. According to some estimates, US pension funds have lost about $1 trillion between July 2014 and March 2015 attributable to the strong US dollar. The appreciation in the US dollar after the US elections has further increased the magnitude of the losses.
Fortunately, investors do have a variety of options to deal with foreign currency exposures. The best option will differ from institution to institution and depend on the importance placed on negative cash flows, risk reduction versus value added and, the resources available to select and monitor active currency managers. In this paper we outline some of the choices investors have to address the foreign currency risk in their portfolios and will explain active hedging in more detail.
Option #1: Do nothing , i.e. maintain unhedged foreign currency exposure
Foreign currency return is measured as the difference in the return to an unhedged portfolio versus that portfolio position hedged back into the investor’s domestic currency. Exhibit 2 plots the foreign currency return of the MSCI ACWI ex USA Index since the introduction of the euro in January 1999 until December 2016, i.e. the performance of portfolio #2. The chart illustrates that unmanaged 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. From January 1999 until December 2016, the average foreign currency return has been about zero (-0.26%), but the volatility has been 6.50% and the drawdown has been as high as 29.64%.
It is not a surprise that most institutional US investors fall in this category, i.e. the currency policy is to keep the foreign equity exposure unhedged. In the weak US dollar environment, from 2000 until 2011, US investors enjoyed a windfall as the foreign currency return contributed positively to the performance of international equities. So, the policy of doing nothing to address currency risk was rewarded with a positive return as portfolio #2 performed well in this decade. However, since mid-2014, the foreign currency return has fallen about 25%, causing a significant drag on performance.
Choice #2: passive hedging
Hedging some or all of the foreign currency risk will decrease the risk of the portfolio. Pojarliev et al. (2014) illustrate that by hedging foreign currency exposures, the typical US investor could reduce the volatility of the portfolio. The higher the hedge ratios, the lower the volatility and the decline in volatility is substantial, ranging between 1.17% and 3.18% depending on the time period. Therefore, some institutions use a passive 50% hedge ratio to reduce the volatility of their portfolio.
Yet, passive hedging creates its own problems, from generating negative cash flow when the foreign currency is appreciating to subtracting return due to hedging costs. First, there is no theoretical justification for the 50% hedge number. Why not 40% or 60% instead? A 50% hedge ratio is only justified as a minimum regret hedge ratio, i.e. better than 100% (fully hedged) when the US dollar is weakening and better than 0% (unhedged) when the US dollar is strengthening. Second, there is no reason to have the same hedge ratio for all foreign currencies in the portfolio. Some currencies, like the Swiss franc, act as safe havens and provide diversification benefits. The Swiss franc will typically appreciate during periods of equity market crashes; which would argue for lower or no hedge ratio for exposure to Swiss equities when the goal is to reduce the volatility of the portfolio. Other currencies exhibit high correlations to global equity markets, like the Canadian dollar, and require higher hedge ratios. Third, and most importantly, the word “passive” is misleading in the sense that it implies no risk. In theory, an institution, which has a $1billion allocation to foreign equities, 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 $500 million in the market against a basket of foreign currencies. This introduces a big market timing risk. If the US dollar weakens after the change is implemented, the investor will suffer substantial hedging costs when the forward currency hedging contracts settle.
Exhibit 3 illustrates that between 2000 and 2011, the cumulative negative cash flow would have been as high as 40%, forcing investors to sell international assets in order to cover the losses on the currency forwards. So in our example, the investor will have to pay $200 million during this period. The passive 50% hedge ratio would have lowered the volatility but at the expense of $200 million! Indeed, when experiencing this significant negative cash flow, some US institutional investors who used passive hedging, liquidated their passive hedging program at the worst possible time, as the US dollar bottomed in 2011 after locking in significant losses on the short foreign currency forwards.Download to read more