Currency hedging can prove profitable in a low return environment.
Currency hedging can prove profitable in a low return environment.

Life in a low return world: To hedge or not to hedge?

Currency Strategist Van Luu shows how thoughtful management of currency risks and opportunities can help investors reach their objectives, despite the low return environment.


Russell Investments believe we will see low returns over the next seven to ten years. Pension funds, endowments and individuals may have to adapt their behaviour and strategies or else risk failing to reach their objectives.

Currency risk is often viewed as a by-product of the broader investment strategies that an investor has employed, rather than an asset class in its own right. As such, it can be overlooked by multi-asset investors.

In the low-return environment, there are four strategies that can be employed to manage currency risk and make the most of the return opportunities from currency:

1) Reduce unrewarded risk with static currency hedging
2) Manage currency risk smartly with dynamic currency hedging
3) Seek additional returns with currency factor strategies
4) Employ cost-efficient implementation

In today’s blog, I’ll be looking at the first two strategies on the list: static currency hedging and dynamic currency hedging.

1) Reduce unrewarded risk with static currency hedging

Unrewarded risk

If your portfolio contains unhedged international assets then you are automatically taking on exchange rate risk without being paid for it, i.e. unrewarded risk.  This currency exposure is only a by-product of the asset exposures, not a clearly articulated currency investment strategy from which you expect to earn returns. For example, a typical global equity portfolio (from a UK investor perspective) implicitly holds a long position in a basket of currencies consisting of roughly:

  • 59% US dollar
  • 16% euro
  • 12% Japanese yen
  • 16% in other currencies1

Currency hedging using foreign exchange forward contracts is a useful way to reduce unrewarded risk. By selling an appropriate amount of foreign currencies forward, hedging creates positions that move in the opposite direction to the currency exposures in the underlying portfolio.  In a multi-asset portfolio, currency hedging can be performed in two different ways: statically or dynamically.

Static currency hedging

In a static currency hedging program, the currency hedge percentage remains constant (at 50%, for example). This percentage will not waver, even in the event of economic changes or shifts in market sentiment.

When compared to an unhedged position, static hedging often reduces unrewarded risk without giving up expected return (when looking at an appropriately long period). In chart 1 we’ve plotted the historical risk-return outcome of a standard global equity portfolio against the same portfolio, but statically hedged at 25%, 50%, 75% and 100%.

The chart shows that, between December 1999 – May 2016, increasing the currency hedge percentage would have reduced portfolio risk without impacting realised portfolio return.2 As we can see, the unhedged portfolio has an embedded risk of 15%, whereas the 50% statically hedged portfolio has 14.4% risk.

Chart 1: Static currency hedging reduces risk without affecting return

 (UK investor December 1999 – May 2016)   

Source: Thomson Reuters Datastream, Russell Investments, as at May 2016.


2) Manage currency risk smartly with dynamic currency hedging

Dynamic currency hedging

Under certain circumstances, the sensible decision to protect against unrewarded currency risk by static hedging (rather than having unhedged currency exposure) can prove counterproductive. Take for instance, a period of market turmoil…

Flexible navigation

Periods of market turbulence often see investors pile into so called ‘safe-haven’ currencies (such as the US dollar). Unfortunately, hedging safe-haven currencies in these times can harm a portfolio’s diversification properties because these currencies typically appreciate when risky assets fall. Flexible and dynamic currency hedging in a multi-asset portfolio can therefore be very useful during such times.3

Unlike static currency hedging, dynamic currency hedging percentages can vary on a regular basis.  This is because the hedging percentage is altered as market circumstances change. Successful dynamic hedging therefore, can circumnavigate unexpected and large negative cash flows, reduce portfolio risk and raise the return from international equity investing. As we show in chart 2, dynamic hedging would have increased portfolio return by more than 1% per year at lower risk, thereby enabling investors to capture the international equity premium more efficiently.

Chart 2: Dynamic hedging model can be more efficient during periods of market turmoil (UK investor December 1999 – May 2016)   

Dynamic currency hedging can be more efficient during periods of market turmoil

Source: Thomson Reuters Datastream, Russell Investments, as at May 2016.

Take for instance the Brexit referendum on 23 June 2016. Statically hedged investors mostly generated large negative cash flows as the pound weakened before and especially after the referendum. Using dynamic hedging in chart 3, we can see that investors would have suffered much less than their statically hedged peers. We use signals from so-called currency factors (which will be explained in part 2 of the series), which picked up on the weaker pound trend in 2016 and kept hedge percentages below 20% throughout.

Chart 3: Cash Flows during Brexit 2016

Cash flows during Brexit 2016

Source: Thomson Reuters Datastream, Russell Investments, as at June 2017.

In part two we will be looking at how to achieve additional returns with currency factor strategies and learn about the various benefits of cost-efficient implementation in a multi-asset portfolio.

 


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1We have defined a ‘typical global equity portfolio’ as per the holdings within the MSCI World Index, as at 31 May 2017
2As measured by the annual standard deviation
3Dynamic hedging can also work well during strong periods of growth in markets.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.