“The question of whether, when, and how to hedge foreign exchange risk has been a vexing one for investors since the end of the Bretton Woods system in 1973.”
Probably, if you do not live in the US 🙂
Anyhow, we don’t so yes, we care. That’s the incipit of this great paper written by gentlemen at Man Group (by the way, if you want a deeper dive, I have also written about the FX problem here and here).
I liked this study for multiple reasons:
- they examine many currency pairs and do not emphasize just the USD (as a long or a short)
- they do not focus on risk mitigation but consider return-enhancements too
- they incorporate value, carry and trend factors
Throughout this post, I try not to be blinded by confirmation bias…but it will be difficult. I come to this topic with my ideas, hopefully I’ll manage to challenge them as well.
Unfortunately, the study considers only equity risk but most of its conclusions can be translated to multi-asset portfolios:
- baring some really low-risk portfolios, many non-stock-only ensembles have a volatility profile closer to equities than not
- while the paper includes a great analysis of FX-stock correlation, trend, carry and value matters whatever the assets in your portfolio
“Fully hedging FX risk may not minimize risk. The returns of an asset one seek to hedge may be influenced by changes in exchange rates, even when those returns are expressed in the local currency. For example, the revenues of stocks in an equity index may be partially earned in a foreign currency. Similarly, input prices may be impacted by foreign exchange rate movements. For example, the FTSE100 index of the largest U.K. stocks will have FX exposures because global businesses inevitably derive their earnings in a range of different currencies.”
I’ve hammered this FTSE100 example so. many. times. People buy the UK index to “get exposure to the UK economy” and, most likely, to “get exposure to the GBP”. In contrast, the index is full of exporters that are linked to the global economy and, crucially, go up in price when the GBP/USD goes down. A EUR investor buying an FX-hedged FTSE100 would get a ton of exposure to the USD.
[quick note: the paper includes EM currencies but my comments refer only to the DM part of the analysis]
World Equity Basket Weights
The paper provides an insightful representation of the currency weight movements, restricted to the currencies used, throughout time. Today’s relevance of USD compared to anything else is staggering but the picture is a reminder of how things can (and probably will) change.
Carry
“it is important to take expected returns into account when making a hedging decision. A good example of this is carry. The interest rate differential between two countries creates a tension between the hedging and no hedging decision. That is, if the home country is a low relative interest rate country, the hedging decision should be different than if the home country is a high relative interest rate country“
Finally, FINALLY, I can show you some numbers behind this concept.
The EUR has been a low relative interest rate currency for so long (and I do not see this changing in the future) that EUR investors should pay attention. And GBP investors too, now that the UK has turned (again) into a high relative interest rate country.
If you have any doubts that carry works, look here (IRD means Interest Rate Differential compared to USD):
Pretty compelling, innit?
While it might be complicated to hedge/un-hedge different parts of the World equity basket, the fact that the USD is such a large percentage of the index facilitates the job. For a EUR investor, hedging (or not) the JPY and CHF doesn’t make a huge difference: they can keep unhedged equities. Conversely, GBP investors should run a 100% hedge portfolio, considering no DM currency has a higher interest rate.
Otherwise, a EUR-based investor can calculate the % or the World Index that has IR lower than EUR and then invest X% in a hedged World ETF and (1-X)% in an unhedged ETF, reviewing the %s once a year and/or if the %s move significantly in the meantime. As shown in the table, DM currencies generally tend to hold their high or low relative IR status: non-USD retail investor does not have to change their FX hedging stand too often.
The biggest push-back against carry is that it stopped working when Central Banks around the World brought all interest rates to (around) zero in concert. It makes sense, intuitively: when you need differentials to drive your decisions, you are left wandering in the dark if all IR are the same. ZIRP lasted for such a long time that maybe the carry phenomenon was just a fluke of the (not so-recent) past.
The Max Carry approach works also from a Sharpe ratio point of view.
Optimal Hedging
The paper explores more complicated rules involving a low volatility approach, relying on a 3-year covariance matrix, and an “optimal” approach that combines Max Carry and Low Vol.
As you can see, the Max Carry strategy still does a decent job despite its simple rule.
That said, the Min Vol strategy offers interesting insights for historically defensive currencies like CHF and JPY. If we just look at returns, CHF/JPY-based investors should leave their equities unhedged; but if we consider that CHF and JPY are risk-off assets, inversely correlated to stocks, then a fully hedged strategy provides better Sharpe ratios.
Value and Trend
The paper includes two additional strategies that are really easy to follow.
Trend
The trend signal is a simple twelve-month TOTAL Return signal, meaning if the currency of the foreign equity market has outperformed the home currency INCLUDING the interest rate differential, the investor stays unhedged, and vice-versa.
Value
For the value signal, the paper compares the spot exchange rate to the Purchasing Power Parity (PPP)
exchange rates calculated by the Organization for Economic Co-operation and Development (OECD). I think you can find the data here. The rule to decide when to hedge is quite intuitive, I’ll let you think about it 😉
Considering that the rules are REALLY simple, the results are impressive (Blend represents equal weights the Optimal, Momentum and PPP hedging weights):
The Momentum strategy has a lower Sharpe compared to static allocations only in the AUD instance (ITL is not really relevant anymore) and the PPP strategy never underperforms.
The Worst of Times
How these strategies performed during periods of stress? How Max Carry did, considering its own ‘risk-on’ nature? The following Panel shows each strategy’s annualised performance in crisis periods, i.e. S&P 500 peak-to-trough selloffs that exceed 15%:
The Min Vol strategy, unsurprisingly, did well. What is more surprising is the resilience of the Max Carry strategy. Mom seems to be the worst dynamic option but, if you look closer, all that red is just related to EUR; and the strategy is not performing differently from the supposedly conservative Hedged strategy.
Conclusion
Great and ACTIONABLE inputs, innit?
It would be nice to see how these dynamic rules work when applied to the most common lazy portfolios, not only equity baskets. Maybe one day we will have a tool to test it (or we will end up using a USD-pegged currency if Trump is ‘elected’ Emperor of the Western World…).
What I am reading now:
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