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

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

- in Markets



by Van Luu, Russell Investments

At Russell Investments, we believe we will see low returns over the next seven to ten years. Pension funds, endowments and individuals may have to adapt their behavior 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 in multi-asset portfolios.

In a low-return environment, there are four strategies that may be employed to manage currency risk and help to 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, we’ll look at the first two strategies on the list: static currency hedging and dynamic currency hedging.

1) Potentially reducing unrewarded risk with static currency hedging

Unrewarded risk

If a portfolio contains unhedged international assets, then an exchange risk is being automatically taken without being paid, 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 U.S. investor perspective)1 implicitly holds a long position in a basket of currencies consisting of roughly:

  • 32% euro
  • 23% Japanese yen
  • 17% pound sterling
  • 9% Canadian dollar
  • 19% in other currencies

We believe 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. 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 over the long term. In the chart below, 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-June 2017, increasing the currency hedge percentage would have reduced portfolio risk without impacting realized portfolio return.2 As we can see, the unhedged portfolio has a standard deviation of 17.1%, whereas the 100% statically hedged portfolio has 14.3%, a 17% reduction in risk. That’s why some academics have called currency hedging a “free lunch”2.  Periods of market turbulence often see investors pile into so called ‘safe-haven’ currencies (such as the U.S. dollar). Hedging back to the U.S. dollar can be very beneficial for portfolio diversification properties because safe-haven currencies typically appreciate when risky assets fall.

Source: Thomson Reuters Datastream, MSCI World Index, Russell Investments, as of June 2017.

 

2) Manage currency risk smartly with dynamic currency hedging

Dynamic currency hedging 

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