Choices to Address Foreign Currency Exposure
OVERVIEW Institutional investor portfolios typically hold a signifi cant allocation of foreign currency denominated assets. Left unmanaged, this currency exposure functions like a buy-and-hold strategy which receives little or no risk premium and adds unwanted volatility to portfolio returns. In this paper, we discuss the variety of solutions to address foreign currency exposures such as using passive currency management choices or selecting from the different active currency management solutions available.
THE CONUNDRUM FOR INTERNATIONAL INVESTING
Foreign currency exposure is a by-product of international investing. When obtaining exposure to global assets, investors also obtain the embedded foreign currency exposure. The sharp increase in the value of the US dollar since mid-2014 has caused a big divergence in the performance of US equities and unhedged international equities due in part to the depreciation of foreign currencies against the US dollar. Foreign currency return is measured as the difference in the return to an unhedged portfolio versus that portfolio position hedged back into the investor’s domestic currency. Exhibit 1 plots the foreign currency return of the MSCI ACWI ex USA Index since the introduction of the euro in January 1999 until December 2015. The chart illustrates that unmanaged foreign currency exposure is a source of uncompensated risk. Currency has no long-term expected return, because although it is a risk exposure, it is not an economic asset for which a long-term premium exists. From January 1999 until December 2015, the average foreign currency return has been about zero (-0.12%), but the volatility has been 6.63% and the drawdown has been as high as 28.45%. In a weak US dollar environment, from 2000 until 2011, US investors enjoyed a windfall as the foreign currency return contributed positively to the performance of international equities. The positive return from holding foreign currencies might have contributed to the unwillingness to address this uncompensated risk. However, since mid-2014, the foreign currency return has fallen about 20%, causing a significant drag on performance.
THE CHOICES TO ADDRESS FOREIGN CURRENCY EXPOSURE
Although there is no best-practice solution to address foreign currency exposures, institutional investors have the following choices (see Exhibit 2).
- Do nothing, i.e. maintain unhedged foreign currency exposure in international equities
- Hedge at least some (perhaps up to 100%) of the foreign currency exposure
- Use dynamic hedging (D-H) techniques to vary the hedge ratio
- Use active currency management to vary the hedge ratio
- Try to overcome the return shortfall through allocation to currency alpha
Options 1 and 2 are passive currency management choices. Options 2, 3 and 4 represent the different active currency management solutions available. The best solution will differ from institution to institution. But it boils down to two fundamental choices. First, the importance of risk versus return and negative cash flow. Second, investors must decide if they believe that currency managers are able to achieve a positive information ratio after fees over the long run and importantly, if they will be able to identify these currency managers. In the following sections, we will address the available choices in more detail.
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