Investors, particularly institutional investors, increasingly allocate capital internationally in their quest for returns. When investing in stocks and other financial instruments such as commodities and bonds, investors look to both increase returns by not limiting themselves to choices available on their domestic market, while also diversifying risk. International financial markets are increasingly correlated and don’t show the same level of diversity in performance as was the case 10-15 years ago, however, there remains a degree of variation which means, for example, Asian financial markets or emerging markets can have a better year than those in Europe or the Americas.
Four of the primary reasons that investors allocate capital internationally are as follows:
- Wide diversification between asset classes and geographies statistically leads to better returns.
- Financial instruments from different geographies have periods of better performance.
- Developed market multinationals lack exposure to value, small-cap, small-cap value or emerging marketswhich can provide strong returns.
- Currency denomination diversification reduces volatility and risk.
However, there is a lurking danger related to the fourth incentive listed here that can also reduce returns, or magnify losses, in an international investment portfolio: currency risk.
What is Currency Risk?
In investment, currency risk is the risk that currency depreciation will have a negative impact upon assets and the income they may provide from dividends and interest payments. This is particularly related to assets denominated in a currency other than the domestic currency that final returns will be in.
A simple example would be a money manager investing in emerging market equities focused on exports. If emerging market currencies, which often show strong correlation between each other, drop significantly in value over the year against developed market currencies such as the USD, GBP or Euro, this is likely to have a positive impact on exporters. Their products, with a base price in an emerging markets currency, will be cheaper when that price is exchanged into developed market currencies, making them more competitive. The increased sales which will likely result would be expected to have a positive impact on the share price of this kind of company, providing a good return for investors.
However, the share price will also be denominated in the same emerging market currency. If that currency has dropped 10%, 15% or 20% in value against the value of the investor’s domestic currency, that will result in the equivalent hit to returns when they are converted back.
Closer to home, the British pound’s drop in value this year, it lost approximately 20% of its value against the U.S. dollar between the Brexit-vote in June and mid-October, coincided with a strong FTSE 100 rally. Between mid-June and mid-October, the benchmark blue chip Index returned around 18%. An U.S. investor in assets that track the FTSE 100 that had not taken steps to manage currency risk would have lost 20% of that 18% return to the currency fluctuation.
Currency solutions are the ways that investors can limit the impact that currency risk has on eventual international portfolio returns. Currency solutions can be managed by investors in-house but are also often outsourced to specialist currency solutions companies that have greater expertise and experience in managing currency risk. Some of the most common currency solutions investors employ are:
Hedging, within the context of currency solutions, involves taking a short position against a currency that the investor is exposed to depreciating. If, for example, an investor is heavily invested in yen-denominated investments, they will hedge against yen depreciation by taking out some form of short position on the yen. A ‘short’ position means that the investor profits from a fall in the value of the asset in the same way they would profit from a ‘long’ position if the asset appreciates. Short positions are taken via derivatives such as CFDs, options, forwards and futures.
If the yen does in fact fall, the investor will take a profit from the short position, which will balance out at least a part of the hit to returns in the yen-denominated investments which will have lost value when exchanged back into the domestic currency. Of course, if it does not fall, the investor will have taken a loss on the short position. However, over the long term and a diverse investment portfolio with assets denominated in different currencies, hedging in this way has been statistically shown to reduce volatility and increase investment returns.
Hedging strategies are broken down into three main categories of passive hedging, dynamic hedging and strategic hedging:
What is Passive Hedging?
Passive hedging is a currency hedging strategy where the hedge is equal to the value of the investment itself. A passive hedge can also mean that its value is equal to a fixed percentage of the investment. Passive hedging means that the investor has zero to minimal currency risk and is purely focused on seeking returns from the actual investment. If the investment shows a return of 10%, a passive hedging strategy should mean that regardless of currency fluctuations the investor will see a 10%, or very close, return, minus the cost of the hedging.
What is Dynamic Hedging?
A dynamic hedging strategy, by contrast, will mean that the investor increases and decreases their hedged position based on analyses of currency movements. When the investor believes the risk of a fall in the currency their investments are denominated in is increased, they will increase their hedge. When risk is perceived to be reduced, the hedge will be too. The hedge may be increased and decreased several times over the period the investment is held. A dynamic hedging approach reduces the cost of the hedge but also means it will be less effective in compensating currency risk if the hedging strategist is proven wrong in their risk assessment outlook.
What is Strategic Hedging?
Strategic hedging is an approach which lies between passive and dynamic hedging strategies. Strategic hedging will mean an initial set of currency hedging positions will be taken and reviewed and potentially adjusted on a, usually, quarterly on b-annual basis. This reduces hedging costs and also the potential risk inherent in attempting to predict shorter term fluctuations between currencies, taking a longer term trend analysis outlook.
What is Currency Overlay?
Currency overlay is a currency solution service provided to institutional investors who will have a potentially significant number of individual money managers and independent investment portfolios. Rather than the individual money managers or portfolios deciding upon currency hedging strategies, a currency risk strategist from a specialist firm will look at the bigger picture and devise and implement a currency management solution subsequently ‘overlaid’ on all portfolios. This allows the money manager to focus solely on asset allocation without the need to consider the potential currency risk involved.
Practically all institutional investors now employ currency solutions to minimise currency risk, whether this is done on a macro-level overlaid on the combined currency risk the investor’s portfolio of portfolios is exposed to, on an individual portfolio level or a combination of the two. Some investors employ currency solutions specialists directly and some use external currency overlay consultants. Private investors that have international exposure are also becoming increasingly aware of the need to add currency risk strategies to their arsenal if they want to maximise returns in the long term.