Some like it hedged

07 Feb 2019

In a recent paper “Some Like It Hedged”, published for the CFA Research Foundation, I show that there are significant differences in the impact of foreign currency exposure on institutional portfolios depending on the base currency of the investors and the specific composition of their portfolios. In general, investors, whose base currency is negatively correlated to global equities, like the US dollar and the Japanese yen, will reduce the volatility of their portfolio by fully hedging foreign currency exposure. In contrast, investors whose home currency is positively correlated to global equities, like the Canadian dollar, will benefit from keeping some unhedged foreign currency exposure, particularly exposure to the US dollar.

In the case of US investors, 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 5.5-year period from June 1, 2014 to December 31, 2018 the annualized net total returns for a US investor in the 100% Hedged MSCI ACWI ex USA Index was 4.1%, versus only 0.7% 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 annualized foreign currency return was -3.4%.

Exhibit 1 plots the foreign currency return of the MSCI ACWI ex USA Index since the introduction of the euro through December 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 (-0.3%), but the volatility has been 6.8% and the drawdown has been as high as 30%. 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. 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
January 1999 – December 2018


Source: MSCI, Bloomberg, BNPP AM, as of January 17, 2019


Although, there is no easy solution to address foreign currency exposures, institutional investors generally have the following three choices:

  1. 1. Do nothing, i.e. maintain unhedged foreign currency exposure
  2. 2. Hedge 100%, or at least some of the foreign currency exposure
  3. 3. Use active currency management to vary the hedge ratio

The best choice to address foreign currency exposure will differ from institution to institution, but it boils down to two fundamental factors. First, the optimal solution depends on the importance of risk versus return and the institution’s tolerance for negative cash flow. Second, investors must decide if they believe that currency managers are able to achieve a positive information ratio over the long run after fees, and importantly, if they will be able to identify these currency managers. Any currency policy will depend on the details of the specific portfolio, particularly on the base currency of the investor and the size of the foreign currency exposure.

Read the full paper