Ray Dalio explains the various strategies on offer for those who wish to hedge their currency exposure – the prudent thing to do when international exposure reaches 15 per cent of a portfolio.
Investing internationally is a package deal. One gets two exposures – the underlying asset and the currency – wrapped into one. These exposures, however, are separable through currency hedging. International investors can and should decide first, how much of each to have and second, how to independently manage these exposures.
Making these decisions, creating a currency hedging plan, is prudent when the international exposure reaches 15 per cent to 20 per cent of a total portfolio. Failing to do so leaves a large, inadvertently acquired, unmanaged risk in the portfolio. The purpose of this article is to provide a basic overview of the key issues that investors should address in developing a hedging strategy.
A general rule to bear in mind when creating your hedging strategy, you should follow the same steps you would follow to decide on any exposure in your portfolio: most importantly, you should decide on the appropriate strategic exposure to foreign currency and whether this exposure should be actively or passively managed.
What should the strategic exposure be?
Phrased differently, assuming no market view, how much foreign currency exposure should I have in my portfolio? The process you should use to answer this question should be the same as the process you use to determine your asset allocation mix. It should be based on the expected returns, risks and correlations of currencies.
Once you have decided on the amount you want to keep in your portfolio, the hedge ratio you set should be the amount that leaves you with your desired net currency exposure. For example, if you determine that you would like to have 10 per cent of your portfolio exposed to foreign currency, and you currently have 20 per cent, you would set a benchmark of 50 per cent hedged. Rather than determining the appropriate percentage to be hedged, you should determine a desired strategic currency exposure and hedge to achieve it. That hedged amount will be your benchmark.
So what is the right strategic exposure to have? As mentioned, that depends on your assessment of the expected returns and risks of currencies, as well as the expected correlations with other exposures in the portfolio. Because currency movements are zero sum – for one currency to go up, another must go down – it is probably best to assume that the expected return is zero, although the actual return might be quite different. This simply means the expected return is zero. The standard deviation of a typical currency portfolio has been about 11 per cent over the past 25 years, which is also a reasonable assumption going forward. The correlations with the other assets in the portfolio depend on the assets, but in general are quite close to zero.
Where will plugging these numbers into a portfolio optimiser take you? While there are a wide range of outcomes depending on unrelated factors (such as the choice of assets in your overall portfolio), there are some common outcomes. Generally speaking, analysis will lead investors to hedge away currency risks, such that the amount left is not greater than 10 per cent to 15 per cent of the portfolio. If your international investments equal 20 per cent to 30 per cent, that might lead to normally being 50 per cent hedged. If your international investments comprise only 10 per cent to 15 per cent of your portfolio, you might opt to remain unhedged.
There are only two characteristics which are unique to currencies that you need to understand to solve for the right strategic exposure:
1. it costs money to hedge and
2. currency exposures are incremental to other exposures, not instead of them.
Concerning the first point, the expected return of being hedged is slightly less than that of being unhedged because of the transaction costs of hedging. These are typically five to 10 basis points (if done passively), so it should be assumed that a hedged portfolio will have a five to 10 basis point lower return than an unhedged portfolio. Given this, you need to assess incremental benefit, what is it worth to reduce or eliminate an exposure that has a standard deviation of 11 per cent and no expected return? One typically sees that risk reduction from hedging occurs in a non-linear way; the benefits of the first 25 per cent or 50 per cent of hedging are much greater than those coming from next 25 per cent or 50 per cent. For this reason, it is rarely the case that being 100 per cent hedged is appropriate.
Regarding the second point, because currency exposures are incremental to other exposures, not a replacement for, lower risk is achieved by having less currency exposure versus more.
Currencies have little or no correlation with other assets in the portfolio. One might think that this is a reason to keep them (i.e. remain unhedged) because they would diversify, hence reduce a portfolio’s risk. In fact, the reverse is the case: having significant currency exposure in a portfolio increases risk, even though currencies are uncorrelated with other assets. This is because currency exposure is additive to other exposures. Normally replacing a higher correlation asset with a lower correlation asset reduces risk because there is a substitution of risk while total exposure is unchanged. When you increase overall exposure (e.g. buy gold futures as an overlay on a portfolio), the effect is to increase portfolio risk, even if the correlation were negative. Similarly, when reducing currency exposure, you will almost certainly reduce portfolio risk, despite currency’s low correlations.
There is only one other point that should be made before concluding the discussion of strategic exposure: the time horizon is relevant. The longer the time horizon, the less risky currency will appear because over a long enough time horizon, its effect on the return approaches zero. If time horizon is a consideration, it is important to understand how long you must wait to be unconcerned about currency risk. Based on past currency movements, in order to be 90 per cent confident that currencies will have an annual return of less than -1 per cent to +1 per cent, you would have to wait 325 years. For most investors, that is too long to patiently accept the unhedged currency risk.
Once desired strategic exposure is determined, you should focus on benchmark exposure and the hedge ratio that gets you there. There are four possible benchmarks – 100 per cent unhedged, 100 per cent hedged, partially hedged (e.g. 50 per cent) and option hedged. All four can be obtained passively. Option hedged benchmarks (e.g. buying puts to hedge the currency exposure) are sometime used instead of a partially hedged benchmark where the investor is more inclined to have currency losses come in smaller, more frequent doses than larger, infrequent amounts. These hedges should not be used as an alternative to fully hedged or fully unhedged benchmarks because they will systematically deliver either more or less currency exposure than is consistent with your strategic objective.
If you choose an option benchmark, it is essential that the one you pick is consistent with your strategic objectives. For example, some options are consistent with a 50 per cent hedged objective, while others are not. Their deltas, sensitivity to price changes, will be broadly equivalent to desired hedged ratios. When choosing an option hedge instead of a corresponding partially hedged benchmark (e.g. 50 per cent), it is also essential to measure the actual performance in relation to the passive option hedge, not the partially hedged alternative. That is because options have different systematic risks than their corresponding partial hedges. For example, options will do better when the markets move a long way directionally. If an active manager is operating to an option mandate, but is being measured against a 50 per cent hedged benchmark, the differences in returns of the manager and the benchmark will be the systematic risk and the manager’s alpha combined. As a result, one cannot distinguish how well the manager is performing from how well options are doing relative to the 50 per cent hedged. For example, a manager could outperform the fixed hedge ratio but underperform the option hedge alternative, giving the mistaken impression that the manager added value when in reality he did not. That is why the benchmark should always be the investor’s passive alternative. For most investors, the option hedged strategy is inconsistent with strategic objectives.
Active or passive?
The only purpose of active management is to add value to the strategic exposure’s passive return. The ‘active’ vs. ‘passive’ decision should be made for currency the same way it is made for other markets: based on expectations for value-added. This statement is true for all managers, whether managing to a fixed benchmark (100 per cent hedged, 100 per cent unhedged or partially hedged), or an option hedged benchmark. The investor should specify the benchmark and study the manager’s performance relative to it.
Investors should also understand and assess how a manager attempts to add value. There are only two ways to add value: fundamentally and technically. Tactical deviations from a benchmark might differ (e.g. price direction, interest rate carries, volatility, etc.), but a manager’s approach to making this bet will be fundamental, technical or some mixture of the two. Fundamental analysis is based on the belief that there are cause-and-effect relationships that need to be understood in order for pricing anomalies to be sensibly identified and acted upon. Technical analysis is based on the assumption that past price relationships are indicative of future price relationships. Whether betting on price, volatility or anything else, managers follow one or both approaches. In assessing currency managers, like any other manager, you should decide on which approach is more consistent with your own investment philosophy.
Since you would only hire an active manager because you expect they are likely to add value, it is worth knowing how they have added value in the past. Brian Strange of Currency Performance Analytics conducted a comprehensive study of currency manager performance in 1998. He studied the performance of 158 currency overlay mandates managed over a 10-year time frame and determined that currency overlay managers have added considerable value, about 1.9 per cent per year on average. Since then, several follow-up studies by other consultants have arrived at the same basic conclusions.
When examining individual managers, it is often difficult to compare their value-added (alpha) because virtually no two client mandates are the same. Judging performance against hedged and unhedged mandates is made additionally difficult by the effect that the market’s direction has on the alpha. For example, managers who are operating to an unhedged benchmark will find it easy to add value when foreign currencies are falling, while managers who are operating to a fully hedged benchmark will find it tough. To achieve the best perspective concerning the managers’ ability to add value, you should examine performance across mandates.
In summary, the alternatives an investor must decide between are expressed in figure one.
An investor’s benchmark can be either a fixed hedge ratio (e.g., 50 per cent hedged) or an option hedge. Active managers can be hired to beat the benchmark, or passive managers can be used to match it. When you are able to check the box that best suits your objectives, you will have moved most of the way toward having a currency hedging plan. Selecting specific managers and deciding on other aspects of the mandate (e.g. is cross-hedging appropriate) is also required, but these choices will be vastly easier to make once you have made the core strategic decision.
Ray Dalio is president and chief investment officer of Bridgewater Associates.
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