Currency Hedging: Aiming for Efficiency

Currency Hedging: Aiming for Efficiency

Institutional investors: Are your currency hedging strategies efficient?

Institutional investors often hedge currency exposure in their portfolios because swings in exchange rates can easily overwhelm returns from investments, especially in today’s low-return environment. A common practice among investors is to build currency hedging strategies specific to various asset classes. Many also hedge investments at a uniform rate, either at the portfolio level or at the asset-class level.

Our research suggests it may be more efficient to make hedging decisions at the portfolio level on a currency-by-currency basis, especially for non-U.S. dollar-based investors. Hedging decisions made at the asset level ignore the relationship between currency exposure in one asset and other parts of a portfolio; imposing uniform hedge ratios at the portfolio or asset level limits one’s ability to benefit from the diverse risk/return trade-offs offered by different currencies.

In fact, our research found Australian and Japanese investors may be able to reduce tail risks (as measured by conditional value at risk (CVaR)) in a standard 60/40 portfolio by up to 1.5 percentage points and 3.0 percentage points, respectively, without sacrificing returns, relative to having a uniform hedge ratio at the portfolio or asset level.

For U.S. investors, hedging may be simpler: Our research showed the potential for no loss in efficiency even with a uniform hedge ratio. However, much depends on the investor’s return assumptions, risk model and portfolio allocations. In general, we believe that portfolio-level currency-by-currency hedging will always be optimal.

Although forecasting currency volatility and returns has always been a challenge, especially for non-U.S.-dollar-based investors, an efficient hedging strategy remains an important way to try to mitigate uncompensated risk. And in a period of low prospective returns, every basis point counts.

For a detailed analysis of our methodology and results, please see the Quantitative Research article “Currency Hedging Optimization for Multi-Asset Portfolios.” (Intended for investment professionals and other knowledgeable institutional investors.)

 

DISCLOSURES

Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.