How do Currency Returns affect my International Investments?Comments Off on How do Currency Returns affect my International Investments?
Many investors take a global perspective when building portfolios to achieve their investment goals. With the potential benefits of an expanded opportunity set and increased diversification comes exposure to foreign currencies. Currency returns can be volatile, creating winners and losers. While there is little evidence that currency movements can be predicted, investors still want to know about whether to hedge their currency exposure.
To answer this question, it is helpful to see whether exposure to currency returns is consistent with the investor’s goal. Some investors may want to hedge currency exposure due to the volatility of currency returns and the impact on a portfolio. In global equities, currency hedging does not meaningfully reduce portfolio volatility, since equities are generally more volatile than currencies. For fixed income, currency hedging can be a useful tool to reduce portfolio return volatility.
This article looks at the impact of currency movements on global equity and fixed income portfolios as well as the merits of hedging.
For investors with unhedged international investments, when their home currency appreciates it has a negative impact on returns; when it depreciates, the impact is positive.
In 2018, the weakening of the pound versus the strengthening of other currencies had a positive impact on returns for British pound investors with holdings in unhedged non-UK assets, and contributed 3.9% from the returns as measured by the difference in returns between the MSCI All Country World IMI Index in local returns vs. GBP.
Currency movements have had a positive versus negative impact on returns for British pound investors with about the same frequency, being positive half the time (12 out of 24 years) as measured by the difference in returns between the MSCI All Country World IMI Index in local returns vs. GBP. The implication for investors is that although currency returns may be volatile at shorter time horizons, they are not expected to be a driver of expected return differences over longer time horizons.
DOES HEDGING REDUCE VOLATILITY?
Some investors may want to hedge currencies with the goal of reducing the volatility of returns. For an investor with a global equity portfolio, hedging currencies tends not to significantly reduce return volatility, as illustrated in Exhibit 1. Equities tend to be more volatile than currencies, so the volatility of an unhedged global equity portfolio tends to be dominated by the volatility of the underlying equities, not the currency movements. As a result, unhedged and hedged equity portfolios have had similar standard deviations.
In global fixed income, hedging currencies is an effective way to reduce return volatility because currency returns are more volatile than investment grade fixed income returns. If the currency exposure is unhedged, the currency will be mostly responsible for the volatility in a fixed income portfolio. As shown in Exhibit 2, the annualised volatility of the hedged index (1.50%) is much less than the unhedged index (8.06%).
For investors with global portfolios, their return is determined by the return of the foreign asset and the return of the currency. However, academic evidence suggests that currency movements are very difficult to predict in the short- to medium-term in a manner that is relevant for making investment decisions.
Should an investor with a global portfolio hedge the currency exposure? The answer depends on investor goals and the underlying asset. For global equities, our research indicates that currency hedging does not meaningfully reduce portfolio volatility. In contrast, for fixed income investors with investment grade securities, hedging can be an effective way to reduce the volatility of returns.
Currency hedging: Establishing a position that mitigates or decreases the risk associated with an existing currency position.
Forward contract: An agreement to buy or sell an asset at a specified price on a future date.
Market capitalisation: The total market value of a company’s outstanding shares, computed as price times shares outstanding.
Standard deviation: A measure of the variation or dispersion of a set of data points. Standard deviations are often used to quantify the historical return volatility of a security or portfolio.
Volatility: A statistical measure of the dispersion, or variability, of returns for a given security or portfolio. Volatility is often measured using standard deviation.
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful. Diversification does not eliminate the risk of market loss.