Currency Hedging Revisited
Currency Remains a Volatile Asset Class
Alfred Lee, CFA, DMS
Investment Strategist, BMO ETFs
Global Structured Investments
alfred.lee@bmo.com
December 3, 2010
Recent Developments:
- Back in May, we discussed the importance of currency hedging in our monthly report, appropriately titled "Currency Hedging Could Be Your Biggest Decision This Year." We further cited how the decision to hedge should not be based on your directional view of currency relationships, but rather as a way to gain pure-exposure to an asset classes. In that report, we also mentioned a number of push-pull factors that would lead currency volatility to remain at elevated levels.
- Since that report, further developments in the global economy have led us to believe that currency hedging is even more important at this point in time. On September 27, 2010, Brazil's finance minister Guido Mantega brought the concerns of an "international global currency war" to the mainstream. As the flood of stimulus money finds its way to foreign markets, increasing currency values in those markets, an increasing number of countries have threatened intervention to keep their exporting industries competitive and their currencies low. In addition, global monetary policies will likely become less coordinated next year, creating increasing interest rate differentials. These factors will likely keep currency volatility elevated, consistent with what is currently indicated by the implied correlations between the Canadian dollar and its foreign counterparts (Chart B).
- Academics have often argued that over the "long-term," a 10-year period, currency hedging has added limited value, if any at all. We refute this argument and believe Chart A clearly shows that currency hedging has added value in the last decade. However, and perhaps even more importantly, the average holding period for securities has decreased over the years. In fact, according the NYSE Group Factbook, the average holding period for a security has declined from 100 months in 1960 (8.33 years) to just 9 months in 2009. That statistic indicates that investors have moved away from "buy-and-hold" strategies, further emphasizing the importance of currency-hedging, as currency risk can result in much portfolio volatility over the short-term.
Opportunity:
- Canada is a market highly concentrated in companies involved in the financial, energy and materials sectors; therefore, attaining exposure to foreign markets is an efficient way to not only tap into regions with higher growth expectations but also diversifying industries.
- As foreign investing involves currency movements, currency hedged products are an option for those investors that desire exposure only in the underlying asset class. Exchange-traded funds (ETFs) are an efficient way of obtaining pure-exposure to an underlying asset class while eliminating much of the volatility due to currency.
- There are a number of ETFs available that allow Canadian investors to access currency-hedged foreign exposure. BMO ETFs offers 11 exchange-traded funds that offer pure-exposure to a number of areas in U.S. equities, international equities, U.S. high yield debt and emerging market debt.
Chart A: The Decision to Currency Hedge Has Been and Will be a Critical Decision
Source: Bloomberg
BMO ETFs (Monthly Returns as of November 30, 2010)
Chart B: Implied Volatility Between Currencies Remain Elevated
Source: Bloomberg, BMO ETFs
Chart C: Implied Volatility Surface of CAD/USD Cross
Source: Bloomberg
*All prices as of December 2, 2010 unless otherwise indicated.
Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individualâs circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.
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