Currency Hedging Can Reduce Risk For Global Investors

Raina Oberoi MSCI	Robert Bush Deutsche Asset Management

MSCI, a leading provider of research-based indexes and analytics, sees compelling reasons for financial advisors to learn more about currency hedging. Raina Oberoi, an executive director in MSCI’s applied equity research team, which has built currency hedged benchmarks, discusses what currency hedging is all about and why it’s becoming increasing important for today’s investors. Joining her is Robert Bush, an investment strategist at Deutsche Asset Management, which has used MSCI’s benchmarks to develop a suite of currency hedged ETFs for equities and fixed income.

Why is currency hedging so relevant today?

Raina Oberoi: Investors across the globe are now allocating more and more of their assets to foreign equities, which is greatly increasing the foreign exchange exposure in their portfolios. (See figure 1.) As a result, currency risk has become a significant portion of overall portfolio risk.

Robert Bush: Investors are reaching overseas to diversify, and our research shows this can fundamentally improve their portfolios. But this has also increased their potential for currency risk. (See figure 2.) An important point that people sometimes overlook when investing internationally (in equities or in fixed income) is they’re essentially long two assets: the security and the currency. Hedging currency risk allows investors to remove currency risk from their asset allocations.

How do investors experience currency risk?

Oberoi: Currency returns (and exchange rates) have a direct impact on the value of any foreign investment. When one invests in foreign companies and the corresponding foreign currency depreciates, this can reduce the gains from these investments. Conversely, if the foreign currency appreciates, then the gains from the foreign investment can be amplified.

What factors increase the potential for currency risk?

Oberoi: A variety of drivers can impact exchange rates and currency returns in the short run, including central bank decisions, changes in inflation, changes in the balance of trade (demand for a country’s goods) and the relative attractiveness of a country’s financial assets based on regulation, policies and investment sentiment.

How does central bank intervention drive currency risk?

Oberoi: When a country’s central bank raises interest rates, bonds and other local assets appear more attractive relative to the assets of foreign countries. Foreign investors seeking a relatively higher rate of return will purchase these local assets and, as a result, the country’s local currency appreciates.

Bush: Policy divergence remains a key trend and is creating a differential in yields. The U.S. Federal Reserve is currently debating the timing of its tightening cycle and when to further hike rates. Other countries still have low, or even negative, rates and are not yet at the point of beginning to tighten.

How do you evaluate currency risk in a portfolio?

Oberoi: There are primarily four things we look at: the implicit and explicit currency exposure in a portfolio, the individual currency volatilities in the portfolio, how currency returns are related to each other and how equity returns are correlated to the currency returns in a portfolio. Some commodity-based currencies like the Canadian dollar and Australian dollar currently have a positive correlation to the equity markets and in such cases a downturn in equity markets can amplify losses since the currency depreciation also adds to negative returns. However, currencies like the Japanese yen and Swiss franc are currently negatively correlated to the equity markets and can have a somewhat neutralizing effect in down markets.

Can you explain the basic mechanics of currency hedging?

Bush: What we do at Deutsche Asset Management—and I think it’s a fairly typical approach in the industry—is we evaluate what our total notional exposure is to a particular currency, in a particular fund. We then sell forward in the one-month foreign exchange market the exact same notional amount of that currency. This eliminates the currency exposure, flattening the long position back to zero. If you roll that every month, you’re effectively continually hedged. Of course, our goal in doing this is to closely track the well-constructed currency hedged indexes that MSCI has created. We’re very fortunate to have partnered with such experts in this field.

What factors should investors consider when deciding whether or not to currency hedge and what ratio to hedge?

Oberoi: Several factors include investors’ risk tolerance, investment horizon and views on the currency markets. In general, investors with short to medium investing horizons should consider the currency impact of their foreign currency investments. That’s because although exchange rates between currencies should revert back to equilibrium in the long term, they can deviate substantially from their equilibrium rate, especially over the short run. If investors don’t want any exposure to currency fluctuation, they can decide to hedge their currency exposure at 100%, for example, while those who want to leave some room to capitalize on the upside of currency movement while maintaining some downside protection could hedge at 50%.

Bush: Perhaps a useful way to think about the hedging decision is to split it into tactical and strategic considerations.

Can you explain these tactical and strategic considerations?

Bush: The tactical level is generally about investors’ convictions concerning short-term currency moves. A good example is Brexit, where it would’ve made sense to be currency hedged through the vote, which came as a big surprise. When the pound depreciated, U.S. investors who had hedged to protect themselves from its potential depreciation got a 15.5% market return, as measured by the MSCI UK Index. Those who didn’t hedge made roughly zero.

Strategic considerations represent a longer-term view where investors need to consider not just the anticipated return, but also the risk, correlation and costs involved. Our empirical research shows that the majority of the time, removing currency exposure from a portfolio has lowered overall risk.

How can investors evaluate the costs of currency hedging? Is it always worth it?

Bush: I would urge anyone to take a careful look at the costs involved. The key driver of the level at which we can sell foreign currency in the forward market is interest rate differentials. When US rates are higher than foreign rates, as they are today in most developed markets, US investors benefit. And when foreign rates are higher, there is a cost.

Your final thoughts?

Bush: We’ve talked mainly about currency hedging equity assets, but the same analysis applies in the bond world—and it’s probably even more critical there in terms of risk reduction. Because bond portfolios have lower volatility, currency risk can have an even greater impact on overall volatility.

Oberoi: Hedging all currency risk is not the straight and simple answer for everyone. However, all investors who are exposed to this risk should make an informed decision whether to hedge or not. Overlooking this aspect can have unwanted outcomes.

You cannot invest in an index. MSCI does not sponsor, recommend or endorse any ETFs or other products or trading strategies tracking any MSCI index. © 2017 MSCI Inc. All rights reserved. DBX Advisors LLC (DBX) is the investment advisor to the Deutsche X-trackers ETFs, which are distributed by ALPS Distributors, Inc. (ALPS). DBX is a subsidiary of Deutsche Bank AG, neither of which is affiliated with ALPS. © 2017 Deutsche Bank AG. All rights reserved.