The Observer

ARTICLES OF INTEREST

Currency Hedging And Diversification – Can Canadian Investors Keep Both?

by James Binny, State Street Global Advisors

The Impact of Currency is Too Large to Ignore but Unhedged Currency has tended to Diversify risk assets
 
Earlier this year we published a paper explaining why the impact of currency risk may be too large to ignore.  Few prudent investors would disagree with this sentiment – particularly given Canadian investors’ level of foreign exposure and long experience of currency swings.  Since April 2011, unhedged foreign currency exposure has added over 20% to the MSCI World ex-CAD return. However, at other times, unhedged currency has cost money ex. 2009 to 2013: it cost over 17%, and it has actually been more over other periods. 

One area of possible pushback is the pro-cyclical nature of the Canadian dollar. This often means that at times of risk aversion and faltering global growth, the Canadian dollar would likely fall while the rising foreign currencies would typically offset the impact of falling equities. 

Is it possible to combine the prudence of hedging against currency losses while benefitting from diversification of foreign currencies?  As we show in this paper, we believe that the short-term diversification properties of currency only benefit long-term investors if they are locked in through a more dynamic process. In this way, prudent hedging can be combined with exploiting the diversification of a lower hedge.

Unmanaged Currency Returns Often Reverse

To illustrate, Figure 1 shows unhedged currency returns in excess of the hedged returns when compared to the local equity returns.  It is clear that during the years of falling equities (on the left of the chart) foreign currencies rise, thus providing diversification.  However, looking at the following 2 years’ return, the move frequently reverses so if gains from the first year are not locked in they will have tended to dissipate.  Interestingly, there are less clear correlation properties when equities are rising on the right of the chart – the relationship is not symmetrical.

 
Figure 1:  Currency unhedged return over hedged return against local equity returns: Nov 1990 – Mar 2018.

Source: Bloomberg/ SSGA

Therefore we believe that the diversification benefits of currency are only of use to long-term investors if they are locked in.  A more dynamic approach to currency management may be able to extract value from those pro-cyclical properties.


The “Optimal” Currency Hedge Varies through Time

At its simplest, it is true that some degree of unhedged foreign currency reduces short-term risk.  The classic demonstration of this is in Figure 2, which shows the impact on standard deviation of international equity returns as a static hedge is increased: the minimum risk occurs around 20% hedged.

 
Figure 2:  Volatility Impact of Static Currency Hedging on the MSCI World ex CAD Index, Nov 1990—Mar 2018

Source: Bloomberg/SSGA
 
However, we would highlight a few points to consider:
  • Firstly, Figure 2 is an average over 28 years – within that there are periods where a very different optimal hedge ratio can be observed.  This can be seen in Figure 3.
  • Secondly, standard deviation is symmetrical – but risks are not always symmetrical and investors are more worried by losses than gains.  We believe that as foreign currencies move from being overvalued to undervalued, the balance of risk moves from losing value to gaining value.
  • Thirdly, monthly returns are a useful measure of volatility.  However, most of our clients have an investment time horizon that is longer.
      
Figure 3:  Volatility Impact of Static Currency Hedging on the MSCI World ex CAD Index,
across sub-periods indicated


Source: Bloomberg/SSGA
 

Risk of Loss and Time Horizon Analysis Point to a more Dynamic Solution

Figure 4 examines risk asymmetrically, looking at the risk of loss as a static hedge ratio increases from 0% to 100% on foreign equities.  This shows the 95% Value at Risk over the period and, over 1 year, would tend to agree that a lower hedge helps to offset the losses on foreign equities.  Using this measure of risk would suggest that a hedge up to 40% will tend to minimise the worst annual losses.  Beyond that level, the worst case losses increase. However, when we look at longer returns – 3 year Value at Risk in Figure 4 – the impact is less clear cut.  This shows that although equity markets can continue in a downward trajectory (the worst case returns are worse), they are less impacted by the level of hedge, so unhedged currency appears to have less diversification benefits (and remember the first of the three years captured the diversification benefit).  Figure 5 shows the change from 1 year to 3 year – demonstrating the value of an increased hedge.

 
Figure 4: Impact of Static Currency Hedging on the Value at Risk of the MSCI World ex CAD Index
Nov 1990—Mar 2018


Source: Bloomberg/SSGA
 
Value at Risk (VaR) examines portfolio risk asymmetrically with a focus on tail risk; i.e. how much is the portfolio likely to lose over a given period? 1 year 95% VaR is the worst 1 year loss with 95% confidence.  We have calculated this by ranking the historic rolling  annual returns and taking the 5th percentile – so 5% (1 in 20) of the historic returns were worse than this number (or, more optimistically, 95% of the returns were better).

Figure 5: Impact of Static Currency Hedging on 3 year Value at Risk relative to 1 year Value at Risk
of the MSCI World ex CAD Index, Nov 1990—Mar 2018


 
Source: Bloomberg/SSGA
 
What does this mean?  Figure 2 confirms that a level of unhedged currency can help smooth short term returns – on the assumption that future correlations between risky assets and currencies will be maintained.  However, Figures 1 and 5 show that the positive currency returns tend not to be sustained.  Therefore the shorter term returns are of little long-term benefit to the end investor, unless locked in through increasing the hedge dynamically.

Dynamic Currency Management can help lock in Diversification Benefits

The question is, ‘how to implement such a strategy?’  We believe that a value based approach is most suitable.  Frequently during periods of growth and risk seeking by global investors, the Canadian dollar as a pro-cyclical currency rises and ultimately becomes overvalued; the opposite happens at times of economic downturn and risk aversion – the Canadian dollar falls and becomes undervalued.  Therefore, it would seem to make sense to reduce hedges as the Canadian dollar rises to benefit from any future falls and to then lock in those benefits when it becomes undervalued.   It is seldom possible to isolate the precise highs or lows, so a gradual process of locking-in profits is desirable. 

Not many investors have the time or governance structure to implement such a process, particularly at times of financial stress. We believe that our Dynamic Strategic Hedge (DSH) strategy can provide the solution. DSH balances the valuation, cost of carry, and currency risk for each currency in a portfolio to arrive at a customized hedge ratio for each currency pair which varies over time. In this way the strategy seeks to add value over the long run while providing lower risk and greater diversification than unhedged or partially hedged currency exposures. In addition to static hedging and DSH, SSGA offers an absolute return strategy or a lower cost factor based (smart beta) strategy investors more focused on enhancing returns using currency.


 
Dynamic Strategic Hedge Ratios as of December 31, 2017

 
Hedging Back Test, MSCI World ex-CAD, November 1990 - December 2017
Historically DSH added 1.15% per year over an unhedged benchmark while increasing the IR from 0.53 to 0.61 and reducing maximum drawdown.

 




 James Binny
 Global Head of Currency
 State Street Global Advisors






James is Global Head of Currency. He joined the company in January 2016 as Head of Currency for EMEA. He is responsible for managing the Currency Portfolio Management team and for driving our strategic vision for Currency.
 
James has 27 years of Foreign Exchange experience, predominantly in investment management, where he has worked on or led teams at firms such as Brevan Howard, Gartmore and County NatWest. He also managed a currency manager of managers product at ABN AMRO Bank. He is well known as an industry innovator, and was one of the first individuals to work on Currency Factor processes over a decade ago. James joined us from Lloyds Commercial Bank, where he was Head of FX Quantitative Solutions. In this role, he created and led the team responsible for advising clients on currency investment processes both for risk and return.
 
James graduated with a first in Engineering Science from Oxford University.

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