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.)