Exposure to foreign currencies is typically a by-product of international investing – by purchasing foreign assets, the investor also obtains the embedded foreign currency exposure. While holders of US dollar assets will have noticed the sharp increase in the value of the dollar since mid-2014, there has also been a big divergence between the performance of hedged and unhedged international equities. Our full article on this topic gives more details of this.
Although there is no easy solution to address the effects of foreign currency exposures, institutional investors generally have these three choices:
- Do nothing, i.e. maintain an 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 investor to investor. 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 choices in more detail.
Do nothing, i.e. maintain an unhedged exposure to foreign currencies
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 relatively 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 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.
Exhibit 1 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 would have had 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!
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 1: Drawdowns in US dollar – passive hedged: significant negative cash flows
Source: Bloomberg, BNP Paribas Asset Management, as of 31/05/2018
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.
Active hedging 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.
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 hedging 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-up 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.